Growth Equity Interview: Behavioral Questions
The fit portion of a growth equity interview is heavily emphasized as much of the job is related to sourcing. Since the associate is usually the first person to reach out to the management team of a prospective investment, he or she often serves as the firm’s “first impression”.
Typically, a substantial portion of a growth equity interview is discussion-based and consists of questions related to one’s interest in a particular industry.
Some introductory questions to expect in all growth equity interviews are:
For each, it would be best to personalize your responses to fit the fund’s investment strategy and industry focus. This indicates to the interviewer that preparation was done in advance and there is a specific reason for wanting to join this firm in particular.
It can be very beneficial to have interest areas that overlap with the focus of the fund, on top of having the proper soft skills to represent the firm. While modeling and learning about the KPIs to track by industry can be learned, interest cannot be taught.
Furthermore, interest in a certain industry can lead to much better performance on the job (e.g., cold calling outreach, networking at industry conferences, contributing at internal firm meetings).
Growth Equity Interview: Exercises
|Mock Cold Calls
- One frequent exercise offered in a growth equity interview is a mock cold call, which will assess the candidates’ ability to ask the right questions in a hypothetical conversation while being personable and leaving a good impression
- To do well in this cold calling exercise, one should:
- Be able to introduce the firm background in a concise manner and right away convey the potential “fit” between the fund strategy and the company
- Ask questions to “management” that pertain directly to determining whether it would be worth scheduling further calls (i.e., straight to the point)
- Show adequate industry knowledge to come across as competent in the industry vertical and having done enough research ahead of the call
- Run the company through the firm’s investment criteria but in a conversational tone without the call coming across as a laundry list of questions
- Another common exercise is being asked to pitch a company of interest
- To present a compelling pitch, it must be clear that:
- The candidate understands the growth equity business model
- Knows the firm’s specific investment criteria based on their current portfolio and past exited investments
- Has interesting ideas and opinions related to industry themes, while being able to defend against criticism and remaining composed
- Going into the interview, candidates should familiarize themselves with one industry vertical and trend, and should be familiar enough to discuss it in detail
- For example, pitching an early-stage company that recently completed its Series A funding round that operates in a very high-risk industry outside of the fund’s industry focus would show that the candidate did not come to the interview prepared
- In connection to the industry trend, candidates should prepare at a bare minimum one company directly benefiting from the tailwind to pitch
|Case Studies / Modeling Tests
- Certain firms will provide modeling tests and case studies, but this is done less frequently than traditional private equity recruiting
- Modeling tests are usually on the easier end (e.g., 3-statement build, simple returns calculation)
- There is more of a focus on understanding the unit economics of the company – and post-completion, the candidate should be able to discuss the company and industry in-depth
- Building a forecast for the company and calculating the returns to the fund properly cannot be neglected; however, it is just as important to integrate opinions regarding the:
- Product-Market Fit
- Prevailing Market Trend and Future Outlook
- Competitive Landscape and External Threats
- Viability of the Growth Plan and Opportunities
Growth Equity Interview: Technical Questions
Q. When looking at a potential investment for the first time, what are some general characteristics you might look for?
- First, the target company should have a relatively proven business model – meaning, the product concept has become established in terms of its use-case and target customer base (i.e., product-market fit potential)
- Next, the company must have benefited from significant organic revenue growth in the past (i.e., in excess of 30%) and obtained a sizeable portion of a defined market, which permits the company to gradually begin introducing initiatives related to upselling and customer retention
- By this point, the company has likely reached a more stable growth rate around 10-20%, which enables the company to shift some of its focus to profitability – but still, the upside for expansion should present significant opportunities, which is the purpose of growth capital
- To accomplish goals related to scale, the business model must be repeatable to expand across different verticals and/or geographies
- Lastly, unit economics improvements should seem feasible – in all likelihood, the company is still not profitable, but a pathway to someday turning profitable should realistically seem attainable and within reach
Q. How does the “proof-of-concept” and “commercialization” stage differ?
- When a company is at the proof-of-concept stage, there’s no working product on hand. Instead, there’s just a proposed idea for a certain product, technology, or service
- The commercialization stage typically refers to the Series C to D (and beyond) funding rounds, and there are usually several large, institutional venture firms and growth equity firms involved
- Thus, it’s difficult to raise much capital; however, the amount of funding required is usually very minimal since it’s only meant to build a prototype and see if this idea is feasible in terms of product-market fit
- Here, the role of the capital and the firm is to guide the company experiencing high growth to get past the inflection point by helping refine the product/service offering and the business model
- At this stage, the investors providing this type of seed investment are usually friends, family, or angel investors
- The commercialization stage is when the value proposition of a startup and the possibility of a product-market fit have been validated, meaning institutional investors have been sold on this idea and contributed more capital
- The focus at the proof-of-concept stage is validating the idea with the goal of showing this potential to outside investors to raise capital
- Especially in highly competitive industries (e.g., software), the focus shifts almost entirely to revenue growth and capturing more market share, as profitability is not the priority
Q. What is growth equity and how does it compare to early-stage venture investing?
Growth equity refers to taking minority equity stakes in high-growth companies that have moved beyond the initial startup stage. Often, the investments made by growth equity funds are referred to as growth capital because they are intended to help the company advance once its product / service has been proven to be viable.
Similar to venture capital firms, growth equity firms do not possess a majority stake post-investment – hence, the investor has less influence on the strategy and operations of the portfolio company.
Here, the objective is more related to riding the ongoing, positive momentum and taking part in the eventual exit (e.g., sale to strategic, Initial Public Offering).
Unlike VC firms, the growth equity firm has less execution risk, which is unavoidable for all companies.
Nevertheless, the risk of failure is much lower in GE. This is because the product idea potential has been validated, whereas product development is still ongoing in earlier stages of the business lifecycle.
Unlike VC investing, where it is widely expected that the majority of investments will fail, companies that reach the growth equity stage are less likely to fail (although some still do).
Q. How does the targeted investment vary between control buyout and growth equity funds?
- Buyout funds take majority stakes in stable growth, mature companies (usually ~90-100% equity ownership)
- Growth equity investors take minority stakes in high-growth companies attempting to disrupt a particular industry
- Buyout funds care most about the defensibility of the cash flows of the LBO target, which means they like stable industries with minimal disruption risk
- For growth-oriented investors, differentiation is a major factor and often the leading rationale for investing (i.e., the value of a product increases from being proprietary and difficult to replicate, or protection from the patent)
- The use of high levels of debt is one of the key drivers of returns in a leveraged buyout, which forces the PE fund to be more risk-averse and constrains the type of industries they invest in
- Debt is not used by growth equity firms or used very sparingly (and most often in the form of convertible notes)
Q. In terms of the industries where potential investments are pursued, how do growth equity and traditional buyout firms differ?
Growth equity is centered on disruption in “winner-takes-all” industries and the pure growth of the equity in their investments, whereas traditional buyouts are focused on the defensibility in profit margins and free cash flows to support the debt financing.
On the other hand, in industries where buyouts take place, there is enough room for there to be multiple “winners” and there is less disruption risk (e.g., minimal technology risk). Industries with higher levels of LBO activity normally exhibit single-digit industry growth rates and are thus mature industries.
Q. For growth equity investors, why is it important to perform diligence on term sheets and capitalization tables?
A term sheet establishes the specific agreements of investment between an early-stage company and a venture firm. The term sheet is a non-binding agreement that serves as the basis of more enduring and legally binding documents later on.
The term sheet facilitates the formation of the capitalization table, which is a numerical representation of the investor ownership specified in the term sheet. The purpose of the “cap table” is to track the equity ownership of a company in terms of number, type of shares (i.e., common vs. preferred), the investment timing in terms of the series, as well as any special terms such as liquidation preferences or protection clauses.
A cap table must be kept up to date to calculate the dilutive impact from each funding round, employee stock options, and issuances of new securities (or convertible debt). That said, to accurately calculate their share of the proceeds (and returns) in a potential exit, it is crucial for growth capital investors to closely examine existing contractual agreements and the cap table.
Q. Compare and contrast the advantages and disadvantages of being a “horizontal” versus “vertical” software company?
- Horizontal software companies provide complete, all-encompassing solutions for their customers, which can be used across a broad range of industries (e.g., Office 365, Salesforce CRM, QuickBooks)
- Vertical software companies target specific niche segments and many can redefine their target industries to meet the needs of underserved markets
- In effect, horizontal software providers have more potential revenue based on the total addressable market (“TAM”)
- If a vertical software company comes in with a product that adds meaningful value, it can quickly establish itself as the industry leader
- Most horizontal companies have time to adjust their strategy as larger markets take more time to saturate; thus, these companies can pivot and narrow their target customer over time based on which end markets are most profitable
- Once market leadership is established, the company can then create a tailored suite of solutions based on their understanding of their end market’s specific challenges and needs – thereby, such companies experience lower rates of customer churn and can incur fewer sales and marketing expenses
- SaaS tends to consist of “winner takes all” markets and only a few companies will end up dominating a market as they become the standard products used across most industries
- By specializing in a particular market, the company is making a high risk-high return bet that it can gain sufficient traction in this focused segment
- Higher rates of churn are seen here as horizontal software companies are better funded and many can afford to offer more features and strategies (e.g., freemium)
- Many of the targeted markets are neglected for valid reasons such as technical hurdles, lack of market demand, specialization requirements, and research & development costs
- Due to the increased competition in horizontal software markets, which tends to be more cut-throat, sales and marketing spend is generally higher given the extensive number of potential customers and the competitive race for customer acquisitions
- The potential revenue might not justify the expenses and level of risk that is undertaken
- Even if the company becomes a market leader, growth opportunities can eventually diminish and force the company to pursue expansion into adjacent markets, making the gap between sales and marketing spending narrow at scale
Q. How do growth equity investors protect against the downside risk?
Growth equity investments involve:
- Minority Stakes (i.e., < 50%)
- Using No Debt (or Minimal) Debt
Those two risk-mitigating factors help diversify the portfolio concentration risk while reducing the risk of credit default by avoiding the use of financial leverage. In effect, these companies can be more flexible and better endure periods of cyclical headwinds.
Additionally, growth investments are almost always made in the form of preferred equity and structured with protective provisions for preferential treatment, as well as redemption rights.
For example, a redemption right is a heavily negotiated feature of preferred equity that enables the holder to force the company to repurchase its shares after a specified period if certain conditions are met – but it is rare to see this exercised in reality.
Q. Imagine that you are meeting with the management team of a potential growth investment. Which questions would you want to be addressed?
- Does the management team seem reliable with the right skill set in being able to lead their company in reaching the next stage of growth?
- What are the long-term financial goals in terms of revenue and market share growth?
- Which factors make the business model and customer acquisition strategy more repeatable to facilitate increased scalability and becoming profitable someday?
- How much value do the company’s products/services provide to their customers?
- Where do the new untapped opportunities for growth lie?
- Does management have a plan for how they intend to use the proceeds from the investment?
- What has been driving recent revenue growth (e.g., pricing increases, volume growth, upselling)?
- Is there a viable exit strategy planned by existing investors and management?
Q. Walk me through each of the funding rounds?
- The seed round will involve friends and family of the entrepreneurs and individual angel investors
- Seed-stage VC firms can sometimes be involved, but this is typically only when the founder has previously had a successful exit in the past
- The Series A round consists of early-stage investors and typically represents the first-time institutional investment firms that will provide financing
- Here, the startup is focused on optimizing its product offerings and business model and developing a better understanding of its users
- The B/C funding rounds represent the expansion stage and still involve mostly early-stage venture firms
- The startup has gained initial traction and shown enough progress for the focus is now trying to scale, which involves hiring more employees (e.g., sales & marketing, business development)
- The Series D round (and onward) represents late-stage investments where the new investors providing capital will usually be growth equity firms
- Investors provide capital under the belief the company has a real chance at undergoing an IPO or a profitable exit to a strategic in the near term
Q. Give me an example of the drag-along provision in use?
The drag-along provision protects the interests of the majority shareholders (usually the early, lead investors) by enabling them to force major decisions such as exiting the investment.
This provision will prevent minority shareholders from holding back a particular decision or taking a specific action, just because a few shareholders with small stakes are opposed to it and refusing to do so.
For example, suppose the stakeholders with majority ownership desire to sell the company to a strategic, but a few minority investors refuse to follow along (i.e., drag-along the process). In that case, this provision allows the majority owners to override their refusal and proceed onward with the sale.
Q. What are the typical characteristics of preferred stock?
Most growth equity investments are made in the form of preferred stock, which can best be described as a hybrid between debt and equity.
In the capital structure, preferred stock sits right above common equity, but has lower priority than all types of debt. Preferred stock has a higher claim on assets than common stock and typically receives dividends, which can be paid out as cash or “PIK.”
Unlike common equity, the preferred stock class does not come with voting rights despite holding seniority. Sometimes preferred stock can be convertible into common equity, creating additional dilution.
Q. What is a liquidation preference?
The liquidation preference of an investment represents the amount the owner must be paid at exit (after secured debt, trade creditors, and other company obligations). The liquidation preference determines the relative distribution between the preferred shareholders and the common shareholders.
Often, the liquidation preference is expressed as a multiple of the initial investment (e.g., 1.0x, 1.5x).
Liquidation Preference = Investment $ Amount × Liquidation Preference Multiple
A liquidation preference is a clause in a contract that gives a certain class of shareholders the right to be paid ahead of other shareholders in the event of a liquidation. This feature is commonly seen in venture capital investments.
Given the high failure rate in venture capital, certain preferred investors desire assurance to get their invested capital back before any proceeds are distributed to common stockholders.
If an investor owns preferred stock with a 2.0x liquidation preference – this is the multiple on the amount invested for a specific funding round. Therefore, if the investor had put in $1 million with a 2.0x liquidation preference, the investor is guaranteed $2 million back before common shareholders receive any proceeds.
Q. What are the two main types of preferred equity investments?
- Participating Preferred: The investor receives the preferred proceeds (i.e., dividends) amount plus a claim to the common equity afterward (i.e., “double-dip” in the proceeds)
- Convertible Preferred: Referred to as “non-participating” preferred, the investor receives either the preferred proceeds or the common equity conversion amount – whichever is of greater value
Q. Tell me about the difference between an up round vs. a down round.
Prior to a new financing round, the pre-money valuation will first be determined. The difference captured between the starting valuation and then the ending valuation after the new round of financing determines whether the financing was an “up round” or a “down round.”
- Up Round: An up round is when post-financing, the valuation of the company raising additional capital increases compared to its previous valuation.
- Down Round: A down round, in contrast, refers to when the valuation of a company decreases after the financing round.
Q. Can you give me an example of when dilution would be beneficial for the founder and existing investors?
As long as the startup’s valuation has increased sufficiently (i.e., “up round”), dilution to the founder’s ownership can be beneficial.
For example, let’s say that a founder owns 100% of a startup that’s worth $5 million. In its seed-stage round, the valuation was $20 million, and a group of angel investors collectively want to own 20% of the company in total. The founder’s stake will be reduced from 100% to 80%, while the value owned by the founder has increased from $5 million to $16 million post-financing despite the dilution.
Q. What is the pay-to-play provision and what purpose does it serve?
A pay-to-play provision incentivizes investors to participate in future rounds of financing. These types of provisions require existing preferred investors to invest on a pro-rata basis in subsequent financing rounds.
If the investors refuse, they subsequently lose some (or all) of their preferential rights, which most often include liquidation preferences and anti-dilution protection. In most cases, the preferred shareholder accepts being automatically converted to common stock in the case of a down round.
Q. What is a right of first refusal (ROFR) and is it an interchangeable term with a co-sale agreement?
While a ROFR and co-sale agreement are both provisions intended to protect the interests of a certain group of stakeholders, the two terms are not synonymous.
- Right of First Refusal: The ROFR provision gives the company and/or the investor the option to purchase shares being sold by any shareholder before any other 3rd party
- Co-sale Agreement: The co-sale agreement provides a group of shareholders the right to sell their shares when another group does so (and under the same conditions)
Q. What are redemption rights?
A redemption right is a feature of preferred equity that enables the preferred investor to force the company to repurchase its shares after a specified period. It protects them from a situation when the company’s prospects turn bleak. However, redemption rights are rarely exercised, since most of the time, the company would not have sufficient funds to make the purchase even if legally required to do so.
Q. What is a full ratchet provision, and how does it differ from a weighted average provision?
- Full Ratchet Provision: A full ratchet is an anti-dilution provision that protects early investors and their preferred ownership stakes in the case of a down-round. The investor with the full ratchet’s conversion price will be re-priced to the lowest price at which any new preferred stock is issued – in effect, the investor’s ownership stake is maintained at the expense of substantial dilution to the management team, employees, and all other existing investors.
- Weighted Average: Another anti-dilution provision used far more often is called the “weighted average” method, which uses a weighted average calculation that adjusts the conversion ratio to account for past share issuances and the prices they were raised at (and the conversion rate is lower than that of a full-ratchet strategy, making the dilutive impact less severe)
Q. What is the difference between broad-based and narrow-based weighted average anti-dilution provisions?
Both broad-based and narrow-based weighted average anti-dilution protections will include common and preferred shares.
However, broad-based will also include options, warrants, and shares reserved for purposes such as option pools for incentives. Since more dilutive impact from shares is included in the broad-based formula, the magnitude of the anti-dilution adjustment is thereby lower.