Estimated reading time: 10 minutes

The article in brief:

• Explore the distinctions between growth and venture financing.
• Examine valuation approaches and use cases that address convertible debt scenarios, IPOs and other exit options.
• Fundraising trends in the startup landscape.
• IPO market trends and the status of special purpose acquisition companies.

VRC’s Ryan MacLean presented on Venture & Growth Equity: Trends in Valuation for the Chartered Business Valuators Institute in a talk that covered a broad overview of the industry, financing terms, valuation considerations, and exit options in a challenging market. Following is an edited summary of their answers to key questions in the space.

How do you distinguish growth equity from venture?

The key differentiator involves product or service completion and sales growth and distribution. For growth rounds, usually, there have already been products shipped or, in tech, deployed amongst customers, and the company is looking for capital for expansion of the top line — additional salespeople, engineering for ancillary products, or to set up the products for clients. From a revenue perspective, usually it’s around $10-20 million in sales, with growth rates that can be in the high double digits for the next few years. Usually, you see that inflection point at the series C round.

Then there are crossover equity rounds — C and C+ — which tend to come later in the game. We started seeing more crossover rounds about ten years ago, often to get an anchor investor that wouldn’t sell in an IPO into the company’s capital stack. Twitter did this. They raised a late-stage round and then went public six months later.

Starting around 2016, companies realized they could do these types of rounds but didn’t have to put themselves under the public scrutiny that comes with an IPO right away. The intention was still to go public, but they started to slow-roll it for a few years. A good example was Uber, which did E, F, and G rounds while it was changing from a growth-oriented, entrepreneurial type of company to one that has real experienced leadership as it has now. A maturing process needs to happen, so having that period to have investors like large mutual funds on your board but not yet going public and not have the volatility of the public markets is appealing from a company’s perspective.

What are typical financing terms and valuation considerations, and what do you look for in a share purchase agreement or an article of incorporation?

Startups are typically in a growth mode and are cash-flow negative, so financing is typically in the form of preferred shares and convertibles. Preferred is most common. The salient terms here will be the ranking/liquidation preferences, conversion prices, and conversion multipliers. You want to read through the documents because these key terms are different. Some are very standardized, but some have nuances: You have participating preferreds, where they get their liquidation preference upfront in a waterfall payoff, and then they start sharing in the economics right away, equal to the common shareholders. That’s different from the standard structure, where there is a liquidation preference. Still, it only converts into common once the common shareholders catch up to the price per share at which it converts.

We also look for cumulative dividends. Often, dividends will be set at 6 or 8%, but they’re non-cumulative. It’s just to protect themselves as preferred shareholders versus common distributions occurring. When they’re cumulative, you get the accrual to 8% every quarter, and your liquidation preference will increase.

We have even seen instances where dividends convert into shares at IPO. So that’s another thing to look for — how the dividends get handled upon an IPO event. We see minimum return hurdles. It’s not just multiples on the liquidation preferences where there might be a 1.75x or 2x multiple, but also even a multiple on invested capital on the IPO. We’ve seen this a couple of times recently: Late-stage investors who come in with money say they want a return not just on the liquidation preferences on the downside but also on the upside. We must read the term sheets, the articles of incorporation, and the purchase agreements to understand the economics before moving on with our valuation models.

What are the valuation approaches for preferred equities?

Typically, there are three approaches: OPM [option pricing model], fully diluted, and EV waterfalls. OPMs are a partial model where each class of preferred equity is structured as a call option on the company, and the question we ask is, at what enterprise value does it make sense to exercise and convert into common shares?

The fully diluted approach assumes they are all common equity and then divvies the ultimate shares.

The EV waterfall depends on the accumulated dividends and how we look through the tier structures.

How do you determine what approach to use for preferred equity?

The fully diluted method represents what happens at an IPO when all shares convert into common, and that’s essentially the intention of most of these companies. It represents the upside scenario.

The OPM represents a wider variety of outcomes, from liquidation on the downside to an upside where everything converts. We look at what the expected outcome is. Series A and B rounds are early in the game and could go many different ways – sales are likely low, and the product is being developed. Or, if it has been developed, it’s not likely proven to have market acceptance yet. In that situation, we’re most likely to use an OPM.

With series E, it could be a $100 million business, with positive EBITDA and evidence of earlier rounds being purchased at the later round price. In that case, investors don’t care about the liquidation preferences, and you want to do a fully diluted model.

Where things can go either way is in that Series C area. That requires judgment: Where do you think it is in the process? Are they still trying to develop the model, or have they reached the point where the company will increase? The key is, what are they going to do with it? Do they think it’s ready to go public? Then, you want to look at it on a fully diluted basis.

The other form of financing we see most nowadays—as a type of bridge financing to avoid down rounds—is convertible debt. Most of the time, the interest will be PIK since the companies are still burning through cash. There will be contractual terms for when the debt will mature, conversion rights at various events, and liquidation preferences.

From a valuation perspective, we typically use a scenario analysis that looks at the exit options:

• Conversion at the subsequent financing round
• Conversion at the IPO or sale event
• Conversion held to maturity.

We typically calibrate the implied issuance yield when we assign the probability of those three options.

When would you change the scenario weighting for convertible debt exit options?

When these deals originally started coming together, they were structured as SAFE notes (Simple Alternatives to Future Equity), straightforward structures that were going to convert at a discount in the next financing round. They served as a bridge–maybe for three to six months–until the company reached the next round. Those models would be heavily weighted toward what we’d expect the next round pricing to be—maybe a 95% scenario weighting toward the exit or conversion and a nominal 5% representing the downside.

We’re seeing the same structure these days, but it’s more complicated because many downside protections are built in. You may be converting at a 25% discount, but if you don’t do that over the next six to 12 months, the discount increases to 30% or 35%.

As you’re getting closer to those inflection points in the agreement, you’ll determine that they don’t have enough time to do another deal, so maybe that 25% discount doesn’t matter anymore—now it’s a 30% or 35% discount.

Suppose you still think the company can raise capital, but it will be much more expensive. In that case, you will attach a higher weighting to the scenario where you get your next financing round at a discount. Conversely, if company performance doesn’t justify that a new round of financing will occur, you push some of the weighting over to the maturity scenario.

An alternative approach for convertibles is using fancy modeling—finite difference models, binomial trees, or Monte Carlo simulations. We can go down that path when the scope or purpose asks for it. Still, scenario analysis tends to be the more common approach because it provides more color and explanations around why we’re doing certain things.

Many startups did their last funding round in 2020, 2021; are those levels still operative?

We’re in a much different environment today—inflation, a higher cost of capital, and prices for public companies, particularly in growth equity, are much lower. So, holding investments at cost versus 2021 is doing a disservice.

Instacart is a good example: They had a valuation of $39 billion in 2021, but they cut their internal valuation several times for employee options, and at their recent IPO announcement, the valuation was around $9 billion—a significant decline for a well-performing company that grew 40% last year. We’d expect most companies to have a similar type of trajectory versus two years ago.

How do you update enterprise valuations from the last round of funding?

We look at year-over-year growth versus the previous period and the underwriting. When our clients initially did the deal, they modeled expectations over the next five years. We want to see how it looks against their original expectations and company forecasts and comps on the public side.

Top-line growth is key. Several years ago, it was growth at all costs; because the cost of capital was so low, you could throw a bunch of things at the wall to see what hit. There’s been a shift, especially over the last year, where you must demonstrate the ability to grow while controlling costs.

If costs go in the wrong direction, we’ll likely hit the valuation because that won’t be sustainable. We’ll look at how much cash they have on the balance sheet, what their expenses are, how they measure up against the liquidity runway, and whether we expect them to be able to compress those expenses. Ultimately, it’s a judgment call. This is where the experience and the art of valuation determine how much we will adjust the multiples up or down.

Looking at the current landscape, most startups raised the last round around 2021, expecting more liquidity in a year-and-a-half or two years. So, many of them are at or near the end of cash burns and need to look for more cash. We’re seeing a lot of insider bridge financing rounds coming in the form of convertible debt.

What are the common features you see in the latest fundraising rounds?

Around two years ago, we saw an inflection point that took a while for companies to recognize fully. They would launch a new round of financing, thinking it would be flat or slightly higher. But there are very few clean rounds these days. More realistically, for companies trying to do some regular preferred equity rounds, you’re talking about a 40 to 60% discount versus the prior round.

If clean preferreds aren’t an option, they go back to some of the insiders for funding, and when it’s a choice of “If I don’t support this company, I lose everything” versus “I may not lose everything if I support this company,” they’re going to consider supporting it. There’s been a pruning of their portfolio—this is in the good bucket, and they’re going to step up and support it, or this is in the lousy bucket, and they’re not.

What does that support look like?

We see new deals with very senior preferences on the preferred side with significant, maybe 2x, liquidation hurdles. Or we see convertibles structured with low valuation caps, meaning they convert at very low implied enterprise valuations; we recently saw one at about an 80% discount to the previous round.

We’re also seeing inducements: If investors don’t provide funding, they may have their shares converted to common. On the other hand, if they do, their older shares might get converted into a new round of financing. We’ve also seen coercive features. In one case, when some large holders didn’t want to participate, there was an 8x liquidation preference to cram everybody down. It essentially said, “We’re going to support them, but, on the downside, we get everything back, and you guys don’t get anything.”

Finally, there is what we call a warrant inducement. Many preferred securities sold a couple of years ago included provisions where investors would get additional shares in the event of a down round. Now, companies are trying to get around those provisions and stem dilution by attaching warrants.

How do IPOs play out in valuations?

We will look at what stage of IPO it is, whether it’s S-1 filing status, or whether there are pricing indications. All these are factors that we monitor as to the probability that the IPO will be successful and at what price. We will create a valuation up to the pricing indications as it goes on. The IPO price may differ drastically from the last round of funding, so we need to monitor developments.

How do you ascribe value to a sale’s various events and milestones?

We have an internal matrix that we developed with clients. First off, the likelihood of deals closing depends on certain stages. Initially, an LOI enables them to start doing due diligence. LOIs come in all the time, and there are a lot of outs for the company and the acquirer, so even though you might have one that says they are going to buy this business for a billion dollars, we’re only going to weigh that about 25%.

Once you get to a signed purchase agreement, there are fewer outs for the acquirer, so we will start bumping that up. We will keep increasing the weighting towards that ultimate sales price when we get even further along.

Are SPACs still a thing?

Historically, SPACs made sense: Individuals with experience in an industry raised money to buy a business or do some roll-up strategy and used their contacts and operational capabilities to create value.

Wall Street, doing what it does, took that to a whole different level a few years ago, when anybody and everybody sold SPAC shares. A primary driver was that sponsors received their promotion up front on closing instead of like a typical private equity deal where they get it on the back end because they created value and made money for shareholders. So, we saw a lot of low-quality deals, and SPACs are going bankrupt or are down 80 to 90% from their initial offering.

It’s less viable of an exit opportunity now for many venture and growth equity companies, but there are still SPACs with pools of cash hunting for a company to sell themselves to. We know of a couple of portfolio companies heading down that route.