103: Venture Capital & Growth Private Equity
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We put Venture Capital and what we call “Growth Private Equity” in the same group. In terms of rules of thumb, Venture Capital invests in consumer brands with $1 million to $10 million of annual sales. Growth private equity invests between $10 million and $30 million of annual sales.
What is Venture Capital looking for?
At BevNET Live Summer 2017, former head of Coca-Cola’s venture arm, VEB, shared Coke’s view of the beverage brand landscape in this slide:
In non-alcoholic beverage, 3% of companies “graduate” to $20 million of annual sales. In my experience, it can take up to $20 million of equity raised to get there. But guess what? Coke, Pepsi, and Keurig-Dr. Pepper, the folks who pay the premium multiples in that category, probably aren’t interested until you are in the $50 million to $150 million range, and they are only interested if they think you will graduate to the next level ($150M+). That’s right, Coke thinks 17% of 16% of 3% (put your calculators away, it’s 0.08%) are “acquirable.” Literally one brand per 1,250 will make it. If the universe is 4,500 brands in Phase I, that means around 3 could get that far.
As most food brands can attest, growth does not come cheap. It’s hard to build a brand that is growing and generating cash flow. Generally, you have to raise outside capital and open the cash burn throttle, particularly in sales & marketing.
Venture Capital
Venture Capital is looking for transformational brands and technologies ([click here] to read about transformation and other terms). By definition, transformational businesses have large market opportunities, perhaps because they are creating new categories altogether. They will accept the risk of investing in something that is up against strong odds.
Generally, Venture Capital invests when you are between $1 million and $10 million of annual sales. Since your business is still relatively unproven, they are looking for validation from other investors, executives, board members, and advisors.
Generally, you can expect to raise $1 million to $5 million from these sources in total. They write $250K to $7 million checks, and generally like to keep “dry powder” (capital reserved for your next round) in their funds for later investments.
Growth Private Equity
Growth Private Equity (“Growth PE”) is a class of non-control investors that is rather unique to consumer. They are hybrids between venture capital and traditional private equity. In a lot of categories, strategic buyers have acquired companies at earlier stages, often as small as $10 million of annual sales. It has certainly happened in food, but in our discussions with strategic buyers, the trend seems to be moving in the other direction. That said, traditional consumer private equity funds have been caught between venture capital and strategic buyers, so they have raised smaller funds, and some of the smaller funds have attached non-control investments to their traditional control approach.
Is Growth PE looking for transformation?
Generally, they will accept less transformation and more incremental change brought by brands in exchange for more proof of concept and growth. They are looking for brands with sustainable business models and margins. If not profitable, they are looking for brands on the path thereto. This means they are looking for companies with at least $10 million in annual sales.
How does valuation work in these transactions?
The mechanics of valuation in VC and growth equity transactions can be confusing, but a simple illustration can often be helpful. Think about it this way: your business is worth $5 million today, this is called your “Pre-Money Value.” Let’s say your rock star team has stock options equal to $1 million in value. On a fully diluted basis, they own 20% of the Pre-Money Value, and you own 80%. The chart below illustrates how it all works.
Say you want to raise $2 million. The day the investment closes and $2 million lands on your balance sheet, what is your business worth? Simple: your company is still worth $5 million plus the $2 million investment, or $7 million. This is called your “Post-Money Value.”
How are these transactions structured?
Usually the newest capital in gets a liquidation preference. This usually means they get their money back plus some sort of accreting dividend. An accreting dividend is a dividend that is not paid in cash, but rather accrues to the total amount the VC invested. For example, if a VC invests $1 million with a 10% accreting dividend, one year from now, her investment is worth $1.1 million. This helps her ensure that you are working hard to aggressively grow the business rather than sitting content in building a little wealth for yourself.
Can I avoid a Liquidation Preference?
Probably not. If you negotiate too hard on this point, the investor will think you’re worried you can’t outgrow their preference. The key term you want to target is conversion. You want their preferred equity to be convertible into common equity on a non-participating basis. “Participating” preferred stock means that the investor gets to keep their liquidation preference and participate in their ownership of common. In the illustration above, this means they get their 1.0x, their 10% accreting dividend, and 28.5% of whatever is left over.
In “Non-Participating” preferred stock, they have to choose. They either get their 1.0x and 10%, or they get 28.5% of the upside. This is key. It means that if you outgrow the 10% per year, they must convert to common, and you are essentially unaffected by the liquidation preference.
The chart below shows the distribution of proceeds based on exit value. This is how you should look at this. See the difference between participating and non? Look at the green shaded area. If they take participating preferred, they get a higher percentage of the proceeds in every case. It’s a creative way to reduce the valuation.
Click here to read 104: Debt.
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