enture capitalists must possess many skills. From being able to build their own brands; being great at networking; knowing the ins and outs of one or more industries, depending on what their perspective fund specializes in, and they must be great at financial analysis.
While analyzing a startup investment opportunity often involves a lot of qualitative assessment, there is a quantitative aspect as well, meaning investors must have great financial acumen and know their way around an Excel sheet. At the end of the day, a company’s financials and valuation drive the overall return and attractiveness of any investment.
Here are four essential financial skills for aspiring venture capitalists.
1. How to create a cap table
Cap tables are incredibly important for any VC investment because they detail who the shareholders are, how much of the company they own, and many other provisions such as liquidation preferences. Cap tables also help shareholders determine what their returns might look like during a potential exit event. For instance, if you own 25% of a company and it is sold for $100 million then your piece of the pie is $25 million. Here’s an example of a very basic cap table.
As you can see, there are different types of shares such as common stock, which is owned by senior management, and then series A and B preferred shares owned by the investors.
Preferred shareholders have higher claims to getting paid back then common shareholders. Another thing to understand about the cap table is that it will change during each funding round as more investors and potential employees get equity, so being able to structure a cap table and adjust it as more investors come in is a huge financial skill aspiring VCs should learn.
2. Different parts of the term sheet
A term sheet is a non-binding agreement between an investor and a startup, detailing the terms of an investment by a VC including how much the firm is investing and the equity the VC will get in return. Additionally, the term sheet lays out a lot of other stipulations including:
● Pre-money valuation
● Liquidation preferences
● Anti-dilution provisions
● Common stock conversion
● Future funding participation
● Board of directors
● Cumulative/non-cumulative dividends
● Voting rights
● Drag along provisions
While not everything on the term sheet is financial, investors need to be very financial savvy to understand all of the provisions and be able to negotiate quickly. For instance, not understanding the dilution that may or may not happen in a future funding round can really hurt your investment.
The pre-money valuation can also get quite technical but is a key driver of the size of the investment and the stake in the company each investor gets, so in order to be an investor at a VC firm, you’ll need to know all of this information cold.
3. Calculating the market opportunity
Understanding the size of the market is critical for any investment and can make or break any potential opportunity. As we’ve written in prior posts, a great company may not be such a smart investment if it’s operating in a small market. Hence why being able to assess the size of a startup’s market opportunity is critical.
A lot of companies may pull statistics from studies or come up with a simple way that they calculate the size of the market. But this is where investors really need to dig in. If a company claims that they have a $2 billion market opportunity, try to understand how they got there. What are they selling and at what price? Who is their target market and how big is that market? Then you need to think about what percentage of the target market the company can actually convert into customers.
Then you want to think about the lifetime value of customers and the product. Is it a one-and-done purchase? Or is it recurring subscription revenue model? Maybe it’s a land-and-expand model, where the company sells one product or service to a customer and then has the opportunity later to sell other products and services and expand revenue with that customer.
Then you need to think about growth opportunities down the line and what other customer segments might be possible to reach. A lot of this is really critical thinking skills but in a very financially-oriented way.
4. Financial modeling
Aspiring VCs should also try and master the art of financial modeling (which can also impress the partners and higher ups at a firm if done on day one). Financial modeling involves building a model to project out a company’s revenue and expenses several years out to try and see what their growth rate and profitability looks like, all of which heavily impacts the company’s valuation, not that there won’t be widespread dispute over the assumptions that go into the model. And these models can actually get quite complex, which is why you’ll see a lot of investment bankers switch over to VC.
Now, one thing to keep in mind is that the importance of financial modeling depends on the company you are investing in. For instance, investors of early-stage companies are likely doing less financial modeling because there’s less to go on that early in the startup life cycle and predicting revenue and costs will be quite difficult.
The startup could also be creating a new market, which might make finding comparable companies and things to base your assumptions on difficult. For early-stage startups it is more important to think big picture, about strategic direction, and any potential impediments that could prove insurmountable such as regulatory challenges or business model sustainability.
But for later-stage companies, modeling can be much more critical because you’re now with a developed company that is likely thinking about an exit through an acquisition or initial public offering.
At this point, competitors have been identified, the company’s direction is much more clear, and there are likely several years of past financials that you can identify trends for and make assumptions on. There’s certainly much more to VC than financial modeling but the skills are critical if you want to succeed in the industry.
Venture capitalists need a diverse skill set, including branding, networking, industry knowledge, and financial expertise. Mastering financial skills is crucial for evaluating investments, such as creating and adjusting cap tables, understanding term sheets, assessing market opportunities, and conducting financial modeling. These skills enable VCs to make informed decisions, negotiate effectively, and project company valuations accurately.
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