Welcome to part 2 of our Private Placement Series.
Previously we covered the basics of why companies go public, primary market VS secondary market, and risk factors.
Today we are going to go in depth about how to thoroughly inspect a deal before you cut your cheque.
There are a few sources of information needed to make an informed decision. Most can be found right in the investor presentation, often referred to as the investor deck (or just “deck”). Anything not included should be asked to your broker, company reference, or whoever else brought you the opportunity.
When it comes to the deck, it typically provides several different facets of information about the company and the deal. Common sections include:
This highlights what the company is about, what problem they solve, and how well and efficiently they can solve it. A few key takeaways from the intro:
- How prominent is the problem they are solving (industry size)?
- Does their business model fall within a trending, relevant sector (industry growth)?
- Are they on the path to revenue, or already currently generating revenue?
- If already generating revenue, is there a net profit breakdown, or EBITDA projections?
Did you know? EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is the ultimate test of bottom line, take-home profitability.
When inspecting a company’s leadership, it simply requires diligence on each member. Of course, a management roster consisting of mostly directors and advisors with few actual operating roles (CEO, CFO, CMO, CTO, etc.) can be a sign of a frothy company.
A few things to investigate regarding each member of management:
- Record of accomplishment with companies they have been involved with,
- A search on any bad press from any companies they have been a part of,
- A glance at the stock chart of any previous public companies they were working with.
Whether your reference for the investment is a broker, a banker, or anyone else, it’s also important to do a bit of research on them and get an idea of the track record and reputation of this person, as well as the entity they work for.
Typically showcased in a readable format called a “cap table”. This is probably one of the most important things to consider when investing in a company.
You could have the greatest company in the world, but with a poor cap table, your dollars may come back in rough shape.
The cap table reflects the way the company is structured in terms of share ownership. This structuring of a company takes considerable knowledge and skill level from bankers, securities lawyers, and capital advisors.
Therefore, a company’s capital markets team can mean everything when it comes to their performance on the market. The people who are structuring the deal, raising the money, and advising the company on their perception to the public market are a crucial part of the company’s success.
A few commonly found terms on a cap table are:
- Founders’ Shares – These are shares issued to the founders and original members of the company and often reflects a lot of the time, dedication, and hard work put in to make. These are usually the first cheques cut and are typically issued at very cheap prices (sometimes as low as a penny). There are typically several million issued, in order to maintain enough ownership in the company as successive dilutive rounds are performed.
- Seed Shares – Seed shares are the early rounds of investments, sometimes referred to as “friends & family.” These shares, although priced higher than founders’ shares, are usually the earliest stage that investors can get in without being a founder. While still carrying risk, as the company is still not as close to the finish line as the IPO round, these shares are often highly sought after due to their early-stage valuation. This is the most commonly recognized stage of “venture capital”, and you’d most likely picture some big shots in suits, cutting cheques to budding entrepreneurs, in order to get to the next level.
- IPO Shares – These are the shares sitting right at the finish line. IPO shares are likely the shares you will come across when being given an opportunity to invest in a private placement. Although these are priced higher than any other financing, IPO shares typically are raised at a valuation that is lower than what the company’s projected valuation will be when listed on the exchange. It is not uncommon to see a company trade at 2-4 times the IPO valuation in the first year.
On a prospectus, or even a deck, not all financing rounds will be categorized this way, or at all. Don’t be afraid to ask questions based on previous financings and valuations of the company when considering an investment.
It is pertinent to know who owns the shares in the cap table. Asking questions based on who holds the stakes in the lower rounds of financings can be advantageous to your decision. Ideally, the shares are held tightly with members of the board and management, or strategic investors.
There is one thing we haven’t looked at yet. Now that we know what the previous financings were priced at, and perhaps who has taken part, we need to look at one final thing.
How long are the shares locked up for?
Most companies put hold periods or “lock-ups” on their financing rounds, in an attempt to limit the immediate volatility of the stock once it hits the secondary market.
Companies will hold many of their shares in a trust, or an escrow, with agreements in place dictating when the shares will be released for free trading, and how many will be released at a time.
Some typical scenarios for each round include:
- Founders’ Shares – These are often held in trust/escrow and released in parts (known as tranches). A common scenario is 6 quarterly tranches with 15% of the securities being released each quarter, and the final 10% being released at the end. At times, these shares may be locked up for 2-3 years. Sometimes there will be a smaller portion of founders’ shares free trading off the bat, often in the hands of market makers in order to provide liquidity.
- Seed Shares – Seed shares are often subject to holding periods, although not as much as founders’ shares. It is common to see seed shares being 25-50% free trading, with the remainder being released in 4-6 months. Although scenarios vary, it is safe to say seed shares are not held as tightly as the founders’ shares.
- IPO Shares – This round of financing is often free trading, though it’s not uncommon to see some structures place 4-6 month hold periods on these. A good company will prioritize its IPO investors before the insiders.
Above all, the total number of shares in existence is not something to overlook. A typical early-stage company has roughly 20,000,000 – 80,000,000 shares outstanding. Although this presents a highly variable range, it’s important to know that when a company has too many shares outstanding at an early level, you’re left with an overly diluted company that is going to have a hard time increasing its valuation to maximize shareholder value.
In short, make sure that:
- The business model makes sense and is relevant to the market.
- You have conducted some research on the management team and their past ventures.
- You can inspect the cap table to make sure there aren’t any red flags, such as too many free trading shares in earlier rounds, over-dilution, or inflated valuations.
We hope you have found this comprehensive guide useful and since venture capital is what we like best, it’s a safe bet we will be touching up on this and other related subjects in the near future. Follow us on Instagram to stay up to date on all of our content and join our Discord server to learn more and speak directly with the Edge team & teachers!