Lecture 2

Question 1

What is a way to determine the behaviour of investors, both public and private equities?

Answer 1

The interest rate environment

Question 2

How does private market reaction compare to public market?

Answer 2

The private market is delayed compared to the public and it impacts later stage private companies more given they are closer to exit and may have to face public markets sooner

Question 3

How does changes in capital markets impact founders?

Answer 3

Impacts how founders operate thier businesses and how employees get compensated causes further ripple effects across the economy

Question 4

Do later-stage companies follow the power rule?

Answer 4

Later stage companies have less risk and therefore don’t follow the traditional power rule

Question 5

What type of companies makes the power law work?

Answer 5

high profile and high risk

Question 6

What can be said about 2021 deal environment?

Answer 6

2021 had more deals than the 4 prior years
- low interest environment (almost at zero) which resulted in a flow of capital

• adds capital to the market from parties that would otherwise not be in venture (corporate funds, wealth managers, commercial banks)
• Floods the market with capital and completely changes the funding dynamics for all

Question 7

What does a low-interest rate environment mean for investors?

Answer 7

They search for yield and profit

Question 8

What is dry powder?

Answer 8

Money a venture fund has that is not invested

Question 9

Whast is the result of high dry powder?

Answer 9

• Pressure to deploy from LPs and desire to look for ways to do so
• potentially result in overpaying for assets and lead to overvalued assets across the market
• Overpaying leads to poor ROI

Question 10

What are the types of investors disrupting the venture capital space?

Answer 10

• Solo Capitalists
• Corporate Venture Capitalists (CVC)
• Wealth Managers

Question 11

What are solo-capitalists?

Answer 11

• Go in and invest money by themselves
• Win deal through empathy, speed and expertise
• Not raising from random parties – big banks giving the power to solo-investors
• Many manage more $$$ than traditional VCs

Question 12

One happened in 2022 in relation to the market and dry powder?

Answer 12

In 2022 everyone stopped investing, and the pace slowed down and the VC’s are sitting on mountains of dry power that they can invest

Question 13

What is a Corporate Venture Capital?

Answer 13

• Slower moving
• Late to market (once they get there its too late)
• Any big corporation you can think of has created this in the last 5 years
• Walmart started a venture fund
• Completed by: creating a new arm instead of paying off the balance sheet which would give entrepreneurs more security
• The partner might not get carry depending on deal structure
• often looking for strategic investment thesis in addition to financial returns

Question 14

What is a wealth manager?

Answer 14

provide holistic financial advice to help their clients grow and protect their wealth. This advice goes beyond just providing advice on a client’s investments or designing a financial plan for them. Wealth managers generally work with clients with a higher net worth

• going into the venture capital space to diversify portfolio and pump lots of capital into companies

Question 15

What are the problem with these new types of investors entering the venture capital space?

Answer 15

Wealth managers, solo investors, and corporate venture capital cause the following:

• inflate the market
• venture capital is not their main focus
• drive up overall risk in the market
• pretend and create the facade that they are experts
• they probably won’t last the full-time horizon of 10 years –> won’t be there when shit hits the fan
• huge risk to the founder (the value add low, and they might be out of the market as quickly as they came in)

Question 16

Describe the deal dynamics from 2009 to 2021

Answer 16

Founders are in control
(more capital than good companies to invest in)

Fundraising was easy
- term sheets out in a week or less

No due diligence
- the breakdown in governance
- no board seats
- If I take time to do the due diligence, I might lose the deal

virtual meetings
- no founder/investor relationship

Secondary transactions everywhere
- founders taking money off the table at all rounds (even seed!)
- VCs would do anything to win the deal

Question 17

What is the impact across the venture ecosystem of upwards pressure on valuations? First and second order?

Answer 17

First Order:
- overvalued companies
- overvalued VC books showing higher value to LP
- employees having highly valued shares
- multiple explosions (companies trading at 100x revenue)

Second Order:
- venture funds raising follow on funds based on book returns
- employees using high share prices to take on debt/leverage
- founders getting rich

Their books look fantastic and so everyone thinks they are rich but its all book return and they haven’t seen return yet

Question 18

Explain how founder culture has evolved in the last few years.

Answer 18

Founders became celebrities and superstars with a magnetic pulsed

Question 19

What was the result of founder-centricity and competitive deal dynamics?

Answer 19

Lack of due diligence

Lack of governance

Funds that only think power law without reflecting on downside protection

Founders had no social contracts or employees and it was 100% driven towards their own empire creation

Question 20

How would venture capitalists justify investments in deploying capital into random businesses?

Answer 20

They would say anything was ‘technology’

• can’t find enough ways to get rid of capitals
• started investing in non-tech things just so they could keep deploying cash (lots of dry powder)
• the more you deploy the more AUM you can manage and the more management fees you can make

E.g., Casper: Mattress online (technology company?)

Question 21

Describe the 2009-2021 public markets environment

Answer 21

Daily Trading Volumes: Sky high in post-covid 2020 and high market volatility

Covid Effect
- market uncertainty
- stock market initial crash
- governments infused $$$ into the market
- people not working
- interest rates were low
- equities took off

Rise of Trading Platforms
- No-fee, easy-to-use trading platforms (e.g., Robbinhood)

Question 22

When reflecting on competitive deal
dynamics in the venture markets coupled
with strong public equity performance
what might this incentivize private
companies to do?

Answer 22

• IPO due to the influx of cash
• 2021 IPOs in the public market popped off

The definition of ‘big outcome’ changed.
- The VC may not have invested prior but due to the rise in public sentiment in public markets may be seen as successful (even at seed stage)

Question 23

What is a SPAC?

Answer 23

a Special Purpose Acquisition Company

Raise a pool of capital
○ Create a holding company with a ‘mandate’
○ The holding company goes public with simply a balance sheet
○ It seeks an acquisition target to acquire, thereby bringing that company
public

Question 24

What are the PROS and CONS of going public through a SPAC?

Answer 24

PROS:
- Faster execution than an IPO
- Upfront price discovery rather than depending on market conditions
- the possibility of raising additional capital (debt or PIPE)
- No road show needed (save marketing costs)
- Companies might have negative cash flows and be valued on future growth, IPO is valued on current growth
- With negative cash flows the company wouldn’tt have passed the test that qualified to for IPO

CONS:
- potential for capital short fall
- compressed timeline (burden on company to have financials and SEC filings)
- Light diligence requirements (incorrect valuations and other financial metrics, lawsuits)

Question 25

What is the relationship between public
and private markets?

Answer 25

• Market volatility
• regulatory changes
• interest rates
• maturity of companies have changed
• regulators want to treat private market like public
  ( the SEC is looking to increase reporting requirements for unicorns)

Question 26

What happens to inflation when interest rates go up?

Answer 26

rising interest rates result in consumers and businesses putting off spending or borrowing. Therefore company’s earnings go down, unemployment goes up.

As demand for goods and services falls, this will cause prices in shops to go down to encourage the purchasing of goods.

INVERSE RELATIONSHIP BETWEEN INFLATION AND INTEREST RATES

Question 27

Explain inflation and interest rates of 2021 and its effects on the market?

Answer 27

During the pandemic, there was low interest rates and people were spending like crazy, then inflation began to rise and we have seen no decline in interest rates.

• layoffs everywhere but unemployment low (covid people might not be looking for work, change career paths, retire, government assistance)

Question 28

What do we want to see as people investing in companies in 2023?

Answer 28

No matter what news, its bad news right now

• if they show high company earnings means that their interest rates are going up
• If they show low company earnings means right now that the company is not successful

Nothing is working right now due to high inflation

Question 29

What happened to software companies in 2021?

Answer 29

Software outcomes are so much larger
than anyone thought’

a. Trading at 50x+ revenue
multiples

b. Companies still negative
EBITDA

Question 30

What are the differences between SPAC and IPO?

Answer 30

SPACs can report forecasts (future growth), whereas IPO candidates
cannot (or have strict regulation on how it’s reported)

A SPAC ‘sponsor’ can profit without the SPAC ever doing well

Question 31

Why did SPACS become popular between 2019-2021?

Answer 31

Market is flooded with capital
so ‘sponsors’ can earn quick
cash

All companies valued on future
growth, not ready for IPO but
capitalizing on exit window

Question 32

What does the term ‘sea-change’ mean?

Answer 32

A complete transformation; a radical change of direction

The Sea Change is due to multiple comprehension, negative cash flows not acceptable anymore (away from growth and towards cash sentiments)

Question 33

Why is the NASDAQ lower than other
market indices?

Answer 33

Smaller companies
Tech-focused

Question 34

What might Index performance over the last year say about diversification?

Answer 34

Not confident that if you make one investment it won’t be the right one
If the market falters, as it will, you diversify the investor decision making
Remove the risk factor

Question 35

How has the change in public markets recently affect private markets?

Answer 35

Private market is delayed because trading is not daily and re-pricing is daily

wait several quarters to determine investments

Funds are usually 10 years means that capital is committed to you as a GP and so you are not impacted until you have to raise the next fund

Will impact growth companies who are close to IPO

If you care about the public markets and invest too much right now and then they IPO it could severally impact VC value

Seed companies are still being invested in because the exit window is still far away and not near IPO

Smaller round sizes

Question 36

What types of companies are VCs currently looking for in 2023?

Answer 36

Looking for companies with lower burn, truly scalable and can be built in a lean way

Might slow down pace of investing because GP might not want to go fundraising right now in this type of market

Might have defaults on capital calls

Firms are putting money in Seed (competitive) and not in Growth which means series A rounds is sort of a flat round

Down round in growth stage

Growth stage is usually being invested by insiders

Change of how company is governed (board management of GP)

GP might be more involved in process and require more information from company

Due-Diligence is back meaning more oversight, deals take longer to close and take board seats to be more engaged in process

No more secondary transactions (get rich quick no more)

Question 37

How have founders and employees seen financial benefits over the last few years?

Answer 37

Secondary transactions allowed them to sell stock and monetize

Share prices were rising quickly creating a lot of wealth on paper

Companies were exiting quickly and often

With the sea change, it restored the illiquid, long-term nature of private stock, making it less attractive and tangible to employees

Question 38

Explain how employees at a start-up are given stock.

Answer 38

• Employees are issued stock options at a strike price

-The current value of a company’s stock is called the share price
(This is the price a VC would hold the shares at on their books (priced externally by the
market))

Question 39

What is “in the money” mean?

Answer 39

share price > strike price = in the money

Question 40

What is “out of the money” mean?

Answer 40

share price < strike price = out of the money

Question 41

What happens when there are ‘down rounds’?

Answer 41

Share prices drop
○ Strike prices are fixed from the prior 409A valuation
○ Employee shares become ‘out of the money

Question 42

What happens when employee shares are “out of the money”?

Answer 42

They look for other jobs
The ‘Great Resignation

Question 43

Explain the relationship between a publicly-traded software company trading at 25x revenue and how an early-stage venture fund might evaluate a seed round.

How might the venture fund anchor its willingness to pay for the seed round?

Answer 43

Look at product offering of the other company

Look at pathway and trajectory of the previous company

a seed investor would be willing to pay an even higher multiple earlier on in the company’s life

You will have a wider scope of deals

Current public market is not relevant because seed company will not exit for a while

Question 44

Explain the macroeconomic ripple effect that happens across both public and private markets when interest rates begin rising rapidly. In practicality, where are we currently deviating from economic theory?
(ie what about our current situation is inconsistent with how we would expect things to behave?

Answer 44

Corporate earnings have not materially declined, people are still
spending despite high rates

Despite mass layoffs in the tech industry, employees are still finding jobs elsewhere or are not looking for work
a. Globalization
b. Covid
c. etc

Question 45

Benefits and costs of diversification and how it relates to the NAASDAQ performance in 2022

Answer 45

Diversification:
- More opportunities to fund the winner
- Less ownership for each shot that is a winner

As a VC you are investing in technology, so when the market declines there is no diversification against tech, so the entire portfolio declines.

You are diversifying against your own errors (ie pick more companies) not against the market (ie all tech)

Compensation:
Power law: founders will get compensated better because you want to motivate the founder to stay along for the long run. Get the consumer to go and pursue the power law and not take the small pay out

Question 46

Explain why ‘corporate governance’ broke down during the market high and what some of the risks are of ignoring governance. Use several examples to highlight your explanation.

Answer 46

Sitting on a ton of cash and need to look at things quickly

Increased competitions in start-up and not due due diligence

Got caught in the glory of building a start up

No power as an investor to adjust deal terms

Lack of relationship-building