I'm pretty familiar to the diligence process for traditional private equity but I'm curious how different it is for growth equity. Is there just a data room that the company uses to drop in financials and other documents?
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I assume that you're meaning minority growth, or late stage venture, not growth buyout. If so, The main difference lies in the complexity of the financial modeling and the wrangling of banks/advisors.
A growth shop is still going to check the box on the diligence items--market, competitive positioning, company, comps, etc. The difference is that the modeling is not done for a control buyout, so the standard 3 statement model makes less sense, and the modeling you do it much more scenario driven and takes into consideration dilution of future rounds.
So for example, my models will have various revenue and EBITDA scenarios, modeling down to cash flow, and then we'll make assumptions for each case on the growth rates of the revenue drivers. We'll model in the current revenue or EBITDA multiple and what we figure it will be farther down the line and then find out what valuation we'd have to get to after dilution of rounds to achieve our target return. You'll have your standard return waterfall, and of course you model in whatever complexity the shares hold (e.g. preferred or common, etc.)
There's also cap table modeling where you start with the current raise, make assumptions for future raises, and show the FD cap table at various raise points.
So the financial output of the investment deck is typical the various scenarios of up, standard, bear, and the returns in each case. That's in addition to the rest of the deck that details the current market and competitive positioning, your standard PE diligence deck.
Thank you for this write up! This was definitely helpful. As someone who has experience in this field, are you aware of any sources or practice models for minority growth equity? Would love to get a better understand of it.
I'm not aware of anything that is specific to minority growth equity unfortunately. However, if you want to practice, I'd do the following:
1) Take a regular paper or mid-level LBO, strip out the sources and uses part.
2) Model down from the income statement to cash flow, using dynamic assumptions. Make the revenue growth % larger in general.
3) Make a pro-forma cap table, based on an owner currently having, say, 20% equity, with a 10% option pool, other employees having 10% thus far, and investors having the rest
4) Assume a 5x revenue multiple (or whatever) and a ~20% of TEV raise, and assume 1M shares to begin with in the split above
5) Model out the change in the cap table: One column for Fully Diluted (FD) shares before the transaction, next column for the number of shares created, and final column wit the FD share count
6) Use the % ownership from the cap table (your shares divided by total shares) and, for simplicity now, assume no further raises
7) Assume a 3x revenue multiple at exit or whatever you think would be fun/reasonable
8) Then show the waterfall of whoever gets paid out, and create your standard MOM and IRR.
This would be a relatively standard template to follow for a GE modeling test, I think. Hell, I might even make 2 or 3 of these and sell them for $10 a pop ;)
Would you mind outlining a bit more of what the diligence process looks like from a 3rd-party standpoint? How deep is the tech diligence, accounting diligence, what sorts of legal workstreams are there, do you ever do HR and RWI?
In 2020 and 2021, there was none! Literally.
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