Masterclass The Art of Evaluating a Deal — Part 1

Deal Dynamics, Part 1

Written by

Mark D. Edwards

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4 min

How do venture capitalists select the companies they invest in? What do they evaluate—and how? Welcome to our four-part Masterclass blog series. We’ll walk you through how we evaluate deals at Alumni Ventures. This first installment delves into the Deal Dynamics that shape our investment decisions.

These blogs were born from our experience with Masterclass webinars, where we explain venture capital and how VCs invest in a fund. Our core mission at Alumni Ventures is to offer individual investors access to professional-grade venture capital portfolios. But it’s also important to us to serve as an information and education resource for our investors.

We hope this series removes some of the mystery behind venture capital while adding an appreciation for the “art” of evaluating a deal.

Deal Dynamics

In this first segment, we explore Deal Dynamics. Venture investment returns predominantly come down to the success of the individual companies you own. However, constructing a portfolio with a consistent focus on investment deal dynamics (i.e., runway, round composition, and valuation/terms) can help set you up for success. Or at least avoid setting yourself up for failure.

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    Runway

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    Round Composition

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    Valuation / Terms

So, let’s start with round sizing, evaluating the magnitude of the round relative to the company’s capital needs. Many venture companies tend to raise equity in a series of success-based rounds (Seed, Series A, Series B, etc.), which are ideally tied to progress in executing their business plan. This system helps manage risk for investors, who can build positions in stages over time. It also enables founding teams to preserve greater core ownership in their companies, which benefits the entire ecosystem.

But it introduces the question of how to size a specific round relative to the cash needs of the business. What level of “runway” what level of “runway” (available cash) compared to “burn rate” (rate of spending) is optimal to investors?

Runway

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    Investment Team's Score

    [X] out of 8

✔ 6-8: Current fundraise provides 24+ months of runway, given cash on hand and projected monthly burn

✔ 3-5: Current fundraise provides 12 to 24 months of runway, given cash on hand and projected monthly burn

✔ 0-2: Current fundraise provides <12 months of runway, given cash on hand and projected monthly burn

While there’s no universally correct answer to this question, we generally like to fund rounds that provide at least 8+ quarters of runway. Though many founders are constantly focused on the need to raise capital, we feel that providing sufficient time between rounds to prioritize investment and execution is vital to building companies of enduring value. With this in mind, we evaluate runway in a “base case” scenario, plus stress test the timing assumptions of anticipated commercial progress and understand what levers management has available to extend runway in the case of delays.

Round Composition

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    Investment Team's Score

    [X] out of 12

✔ 10-12: Current round led by a new investor; lead investor from prior round taking at least pro-rata

✔ 7-9: Current round led by an existing investor taking super pro-rata; lead investor from prior round taking at least pro-rata

✔ 3-6: Current round led by a new investor or existing investor taking super pro-rata; prior lead investor not taking pro-rata

✔ 0-2: Current round led by existing investor not taking super pro-rata

We also evaluate the composition of the round. Many venture financings are composed of a syndicate of investors — some new, some existing, some more active, some more passive. While most of our fundamental due diligence is completed independently in direct contact with the issuing company, there are signals in the behavior of others that we factor into our decision making.

    • Does the round include a new first-time investor showing commitment with a large dollar investment and a seat on the board?
    • Are existing investors continuing to support the company, maintaining their ownership in the company (‘pro-rata”) or even increasing their stake?
    • Are any existing investors leaving the board or otherwise disengaging from the company?

Evaluating these issues thoroughly can sometimes feel like navigating the plot of a spy novel, but it’s important to be clear eyed about overall investor motivations and alignment before making an investment decision.

Valuation Terms

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    Investment Team's Score

    [X] out of 10

✔ 8-10: Deal relatively inexpensive / discount to market value

✔ 6-7: Deal priced at market value

✔ 4-5: Deal priced slightly above market value

✔ 0-3: Deal is overvalued or there are terms that make positive exit a higher hurdle

Third, we evaluate the valuation and structure of the round. We begin with establishing a sense of “fundamental” value for a business based on discounted cash flow analysis. While this is essential, the work has obvious limitations in evaluating venture-stage companies, given the difficulty of accurate, long-term forecasting. As a result, we supplement it with a more practical assessment of “relative” value based on similar transactions in the market. This is an area where broad, consistent investing gives us strong informational advantages. The challenge is to refuse to allow the “market” to justify decisions that are at odds with core analysis.

When it comes to structure, it’s important to understand if there are any special rights or provisions for specific classes of security holders. We are especially focused on identifying any blocking rights or provisions that could impact our flexibility at exit to capture full value.

To learn more, view our latest webinar: Masterclass Live! The Art of Evaluating a Venture Deal

See video policy below.

Case Study

To show how these factors play out in a real investment, we’ll point to a recent evaluation to show how deal dynamics figured into our investing decision.

We recently underwrote an investment round that included the corporate venture arm of a highly strategic investor. The dollar amount of their investment was modest relative to the overall round. However, we valued their participation because they were well-equipped to evaluate the company’s proprietary technology and to accelerate penetration of an end market with notoriously long sales cycles.

Prior to closing, this strategic investor reduced its commitment in what was explained away as a change in internal politics at the parent company. However, our follow-up due diligence highlighted sufficient risks to our original assumptions that we withdrew from the oversubscribed investment based specifically on the change in round composition.

Challenges

Of course, judgment and nuance come into play in all of our scoring. Here are some of the things we’ve run into recently that make the evaluation of deal dynamics tough.

Raising money on the back of a lead VC’s brand name.

We’ve seen many instances of well-known lead VCs offering term sheets to their portcos that include only a nominal investment from the lead. This often comes with disclaimers of a VC “hitting its limit” of diversification, single-company exposure, etc. But it can be a sign that the lead has limited conviction and is lending its brand name to what’s essentially an effort to help the portco build its runway by raising money from other VCs.

Slight change in structure.

We’ve seen an uptick in >1x liquidation preferences and other investor rights that were not offered in 2020/2021. An investor with a 1x liquidation preference gets paid back their full investment amount before shareholders with lower priority receive their payouts. We view this as a delicate balance. While some structure can be “investor friendly,” it can also lead to mixed incentives down the road. It’s important to keep management properly motivated, etc.

Like to learn more about venture investing? Stay tuned for Part 2 in our series and view our latest Masterclass webinar here.

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This communication provides some information regarding Alumni Ventures’ investment process, but is not intended to comprehensive and functions as a summary only. This communication is not personalized advice of any nature.