VC Masterclass: The Art of Evaluating a Deal — Part 1

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.

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?

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.

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.

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.

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.

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

This communication is from Alumni Ventures, a for-profit venture capital company that is not affiliated with or endorsed by any school. It is not personalized advice, and AV only provides advice to its client funds. This communication is neither an offer to sell, nor a solicitation of an offer to purchase, any security. Such offers are made only pursuant to the formal offering documents for the fund(s) concerned, and describe significant risks and other material information that should be carefully considered before investing. For additional information, please see here. Venture capital investing involves substantial risk, including risk of loss of all capital invested. This communication includes forward-looking statements, generally consisting of any statement pertaining to any issue other than historical fact, including without limitation predictions, financial projections, the anticipated results of the execution of any plan or strategy, the expectation or belief of the speaker, or other events or circumstances to exist in the future. Forward-looking statements are not representations of actual fact, depend on certain assumptions that may not be realized, and are not guaranteed to occur. Any forward-looking statements included in this communication speak only as of the date of the communication. AV and its affiliates disclaim any obligation to update, amend, or alter such forward-looking statements, whether due to subsequent events, new information, or otherwise.

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.