Thomvest Ventures

An Inside Look at how a VC Evaluates Startups Pt. II

This blog is the second half of a series on how we evaluate startups using our recent investment in Apsalar to provide a practical example.  To read Part I please click here.  This blog covers the final 3 phases of the investment process, including: (i) final due diligence and Thomvest internal review, (ii) negotiating terms, and (iii) working together with the Apsalar team to round out the syndicate.

Final due diligence

After the initial review and discussions with the Apsalar team, the next step was to bring the rest of our team up to speed with the Company and to continue the due diligence process.  We craft an internal investment memo to clearly explain the investment opportunity and to ensure that we have done the work needed to fully understand the company’s value proposition and market position.

Topics that we typically cover in our investment memo include:

1. Investment Summary
   • An overview of what the startup is trying to do, how much we are proposing to invest, what we think the total eventual capital required will be (including our portion), what percentage ownership that might leave us with, and what type of exit we might expect for a successful company in the market being considered.
2. Team Description
   • Who are the founders and leaders of the company?  Have they had success with their previous endeavors?  Does the team demonstrate enough tenacity and willingness to learn in order to become successful?
   • What is the culture of the company?  Is it an engineering- or product-driven organization?
3. Market
   • Who are the primary competitors?  Are they large existing companies or other start-ups?  What are the competitive advantages of the company being considered?
   • We usually create our own analysis of the startup’s TAM (Total Addressable Market), which is used in turn to get a sense for how large of a company the entrepreneurs might be able to create if their product or service is successful in its market.
4. Comparables/Potential Exit Pricing
   • Has there been other M&A activity in similar segments of the market, and if so, on what multiples did it sell (revenue, EBIT, strategic value, traction, etc)?  To give you a better sense for this, we’ve included the sample we used in our Apsalar investment memo:
5. Operations
   • Required headcount.  In particular, what sort of engineering talent, sales and marketing resources will required in order to scale?  How quickly does the company burn through cash?  How well do they understand the key metrics for measuring their own business?
6. Financial Performance
   • We generally build upon models that the startup management team gives us, or generate some rough estimates on how we think the company could grow.  While it is difficult at an early stage to come up with concrete revenue estimates, the exercise helps us to focus on the key levers that will determine the performance of the company and help us figure out what happens when they are tweaked.  For example, if a company relies on CPC or CPM advertising revenue, we can model the impact of a price change.
   • When thinking of the downside, we often think it is wise to assume the rule of 3 when evaluating a startup’s financial forecast.  Namely, that building a successful company will take three times as long, require 3 times more capital, and generate only a third of their forecasted revenue.
7. Merits
   • Concise statement of why we like the company
8. Issues/Risks
• What could derail the startup?
• Call notes -These are in effect the ‘raw data’ from reference calls we’ve made with customers, partners or industry experts.

During the preparation of our Apsalar investment memo, we continued to have discussions with the team, customers, and contacts who were experts in the company’s industry.  In the case of Apsalar, these discussions continued to build upon our initial enthusiasm for the company and the team.  Our reference checks for Apsalar made us comfortable not only with the investment but also swayed us to propose a higher pre-money valuation than we would normally offer such an early stage company.

Negotiating terms

After debating the pros and cons of investing in a startup, the group usually comes to a consensus opinion.  If we decide to move ahead, the next step is drafting a term sheet to present to the company.

The two things that matter in term sheet negotiations are control and economics.  For the first, we generally make our term sheets founder-friendly, and this is especially helpful when a startup receives interest from others in their financing round.  Throwing in severe terms makes it less likely that you will be viewed as a partner or will even be chosen as an investor.  For example, we typically do not include a full ratchet anti-dilution because we find it to be too draconian , and we do not pressure founders with exploding offers that forces them to make a quick decision.

Valuing an early stage company is typically more art than science.  Often market supply/demand and how much interest your funding round is receiving will dictate the way the conversation goes.  Some VCs get to a valuation number by working backwards from a targeted percentage ownership that they generally like to receive and use that as a basis for how they think about valuation.  Given our unique structure (we are investing our own funds, and don’t need to raise outside capital) we are typically more flexible in this area and focus on being part of a great company rather than how the specific ownership percentage pans out.  That doesn’t mean we won’t negotiate or try to get a fair deal, it simply means that we won’t necessarily get caught up over fighting for an additional 1% ownership of a company or balk if we don’t meet a certain ownership threshold.  The foundation for understanding how these proposed economics will impact a startup is the capitalization table (cap table).

We built this cap table to provide a blueprint for founders to help them envision what the ownership of their startup might look over a number of financing rounds.

Thomvest Sample Cap Table –

Depending on who you ask, there will be a multitude of opinions on what a standard or optimal capital structure might look like, and while we did put some round numbers that we think reflects the progress of an average startup’s capital structure, the numbers will change drastically depending on the circumstances of the specific company being considered, the market conditions, etc.  A few of our assumptions:

1. We assumed that option pool increases would occur after a financing round closes, and that 50% of options are granted between each financing round.  It is important to note that the timing of an option pool increase may change, and could have a big impact on the valuation of your startup.  If you are interested in learning more, we would suggest reading an excellent article by our friends at Venture Hacks.
2. We assumed that Angel investors did not follow on in subsequent rounds.  Sometimes Angels will exercise their pro-rata rights or increase their commitments, but more often we see Angels who are content with keeping their investment restricted to the seed round.
3. We assumed that a company would take venture debt and bring aboard a strategic investor in the later stages of their financing rounds.  Current venture debt interest rates are quite favorable, and we have seen a number of our companies take non-dilutive financing to fuel their growth.  In addition, strategic partners may provide an additional sales channel or value once a startup is established.  At the same time, some companies have grown substantially without taking venture debt or a strategic investment.
4. We left in our own analysis at the bottom so you can see how a VC thinks of their ownership over time in relation to their total preferred and fully diluted ownership percentage.  Not only can this be used to determine what would happen in the event of an exit, but we also use it to determine our voting rights.

While explaining the nuances of cap tables could take up a few blog posts on its own (feel free to ask if you have any specific questions), we wanted to include an example as it played an important role in our discussions with Apsalar.

We decided to do something unconventional and asked Michael Oiknine, Apsalar’s CEO, to come down to our offices before presenting a term sheet.  We took a similar cap table, plugged in the past numbers for Apsalar, and then put in theoretical values for the current financing round with a comparison analysis of how the pre-money and other items affected the founder’s and Thomvest’s outcomes in the event of an exit.  We projected this on the wall, talked through it with Michael, and changed the model with his input on the fly while discussing certain ways to structure the financing round.  At the end, we came to an agreement on terms that both parties felt was fair, and emailed the model to Michael and the company’s lawyer for review.  We followed up with a term sheet that was signed by both parties a few days later.

Rounding out the investment syndicate

During our discussions, we emphasized the importance of leaving a meaningful allocation open for other investors.  If Thomvest was very aggressive on trying to maximize its total ownership percentage, then it wouldn’t leave a meaningful piece for other angels and VCs to join the round.  We were happy to finance more of Apsalar round and even gave Michael the ability to call an additional amount of capital from us if he desired.  However, both Michael and Thomvest felt that building a strong syndicate for the company would be beneficial for everyone.

We tend to prefer to syndicates with other VCs to give startups more collective networks and experiences.  We supplement the existing VCs that a startup has received interest from, and the network of VCs that our team has, with some digging in research databases to screen for the most active investors backing startups in the relevant industry.  In Apsalar’s case, we were fortunate to have both Battery Ventures and DN Capital join the syndicate.  Both firms bring great collective experiences to the team. When we met with Steve Schlenker from DN Capital, we were impressed with his knowledge of the overall gaming landscape and the specific ad monetization challenges that publishers faced.  Many of these insights came from having investments in successful publishers such as Digital Chocolate and Shazam.  Battery Ventures brought a range of experiences with ad networks from their backing of BlueKai, ExactTarget, Freewheel, and Omniture to name just a few of the many companies they’ve helped build.  In addition, the company also had the support from the team at Founder’s Co-op, who had supported the company at the earliest stages both financially and through mentorship.  We were quite pleased at the prospect of working with such a knowledgeable and experienced group of investors.

We hope that these two posts give some insight into how a VC thinks and acts throughout the entire fundraising cycle.  The process may differ depending on the investor; some might agree to fund you over coffee where others might be painfully slow.  We spend a great deal of time digging deeply into a startup’s team and business once we are genuinely interested, and we encourage founders to do the same in respect to their potential investors.  We encourage founders to read an investor’s blog, check out their social media accounts, find startups they invested in that failed and set up reference calls with the founders of those companies so you can see how the VC acts in bad times as well as good, and spend time with the partner that is actually going to be on your board to see if you get along.  While you might be able to pull your entire funding round together in a matter of weeks, you’ll be working with the people backing your company for a number of years.