Entrep Finance & Private Equity 8

We had a “real” fund-raising pitch of the P/E fund manager to us, the potential limited partners. Frankly, the questions both actually asked and those that should have been asked were very much common sense. Fund size, average deal size, where will they invest, how are they different from other people in this crowded marketplace etc. Immediately afterwards we were given feedback by the guy from the private equity fund of funds Adams Street Partners. He didnt surprise except in one case, claiming that we needed to spend more time learning about the culture of these guys and really dig deeper in what kind of people they are.

He mentioned something that was later picked up by our humble teacher, specifically, that VC investing is harder to do and harder to invest into (from the fund of funds perspective) as it is more uncertain. Frankly, it is, but shouldn’t the market reward them somehow? Another point, was that VC companies are never really profitable. Even if its a store network, 5 profitable stores will not yield enough profit to cover the losses arising from the opening of additional 3 stores.

Later we started a review of the VC part of the course. Of the few new things here: revisions to the projections – only if they are obvious, unlike buyouts, where those are extensive and the entire process is much more iterative. Obviously, in the venture deal the tax shields hardly ever appear.

This piece is quite technical. As we know, the probability-adjusted APV departs from the academic way of evaluating risky cash flows. When a VC evaluates a deal that in his opinion has only 50% chance of working out as projections say, instead of multiplying the cash flows by 50% he / she adjusts the discount rate upwards by dividing it by 50%. This is to some extent an effort to reconcile the theory to the rule of a thumb practice: 50% discount rate for the seed round, 40% for the equity growth stage and 30% for the stage immediately preceding liquidity.

Thus, a more rigorous way of evaluating a deal, would be to adjust the discount rate downwards later in the projections as we move closer to the liquidity and the probability increases from 50% to 100%. However, as a seasoned VC Scott told us that he doesnt want to pay for this and advised us to imagine that we are asked to write checks ourselves. I guess, these kinds of insights, that can be only obtained only in practice are priceless in the classroom!! On the other hand if you, as an entrepreneur don’t like it, you may circumvent the problem and arrange your financing in multiple rounds, but you will have to go through the pain of that.

Final comment was related to the use of multiples in evaluating the terminal value. In a “hot” industry, the multiples are very high, and applying them five years down the road isnt valid, because the industry will stabilize with lower growth prospects.

I guess, this is the end of the VC part of the course.