Lecture Patterns of entrepreneurship management (5th edition) - Chapter 8: Funding the venture – Part 2

Chapter 8 - Funding the venture, part 2: Equity and debt financing for high growth. The contents of this chapter include all of the following: Important terms used in equity investment, the current status of the venture capital sector, the venture capital process, the private placement process, bank loans, valuing an early stage company, general guidelines.

Key Terms For Equity Investments 

­ 1

• Equity Investment occurs when an entrepreneur sells part ownership in the company to raise funds

• In Private Equity, shares are illiquid and cannot easily 

be sold until a  liquidity event, also known as an Exit,  occurs

• In doing so the entrepreneur suffers  Dilution as they now  own less of the company

• The value of the company prior to the investment is  termed  Pre­money, and after, Post­money

• Investors usually own  Preferred Stock, which carries  certain  Preferences over the founders(s)

• Convertible Loans are a form on investment that starts out as a loan but can be converted later into ownership

• Investors may also receive Stock Options or Warrants  permitting them to buy more ownership at a later date at a  pre­determined (low) value

• Private Stock rarely pays a Dividend, or if one exits it is  usually accrued until a liquidity event

• A  Stock Option Pool  is part of the future compensation  for key employees. It is listed in the Cap Table.

• Term Sheet is a non­binding agreement to invest

• Due Diligence, a detailed investigation of a company  performed after a term sheet is agreed. 

• Lead Investors source deals, undertake due diligence,  negotiate terms, take board seats. 

Founder A

500,00 0

$500,00 0 45% Founder B 450,000 $22,500 33.33% Founder B 500,000 $500,000 10% Option Pool 100,000 $5,000 6.67% Option Pool 100,000 $100,000

26.67% Investor 400,000 $400,000

Pre­and Post­Money  Cap Table Example

In this example, the two founders sell part of the company for an investment of $400,000 Their ownership is diluted, and they have also allocated part of the ownership of the company in the form of a Stock Option Plan for future employees

Round Status Likely Sources of Funds Expected IRR

Pre-seed* Barely an idea, rough business plan Friends/family, bootstrapping, grants, and

microequity funds

1–40%

Seed* Prototype or proof of principle, no sales Angels, grants, possibly a local VC firm 20–40%

A Round* Development nearly complete, first trials

with customers

Super-Angels, early-stage VC 30%+

B Round Customers, first growth phase VC or other institutional sources of funds 30%+

C/D Rounds

Sufficient to get to cash flow neutrality or exit

Source: Cambridge Associates LLC, 2012

IRR of VC Funds by Vintage Year

The dot.com bubble in the late 90’s fundamentally changed the Venture Capital landscape At its peek VC firms raised a lot of money, but have been unable to achieve any reasonable returns in the last decade In order to invest their large amounts of cash the focus has moved to later stage companies making it very hard for entrepreneurs to get early stage venture financing

Here are these two sets of data superimposed to show the high influx of funds while returns plummeted During the lean years better returns could be attained by putting money into a bank account!

Copyright 20015 Jack M. Kaplan & Anthony C. Warren

Source: PwC/NVCA MoneyTree™ Report Data: Thompson Reuters

However there has been a recent recovery in the VC sector with investments focused on social media and internet scalable

businesses But we are still well below the over-enthusiasm of the dot-com bubble.

Until recently, poor economic conditions have suppressed the Initial Public Offering market, with exits moving to corporate purchases This shift makes building a “virtual” or “essential” company an attractive strategy.

Copyright 2015 Jack M. Kaplan & Anthony C. Warren

• Funds have got larger….

• Money must be “put to work” but…

• New business models can be more capital efficient…

• Resulting partly from the impact of the Internet

• So Entrepreneurs are using other sources of funds

• Bootstrapping is de rigeur in current environment

• New Models have emerged to fill the gap:

• Early Buy-in by VC-funds to “capture” deal - little due diligence

• Micro-equity funds such as YCombinator and DreamIt Ventures combining networking and seed funding

• “Crowd-Funding*” - Internet sourcing of loans or equity

• Virtual companies – use resources from anywhere only when required

* See Kevin Lawton’s site: http://www.trendcaller.com/

• For a typical start­up ­ Venture Capital  Fund will invest 2­3 million for 40% 

preferred equity ownership position.

• This gives VC’s a liquidation preference  over common shares until the 2­3 

million is returned.

• If Venture fails, they have first claim to  assets including technology.

• Also blocking rights over key decisions  including sale of the company or IPO.

• Anti­dilution clauses or “Ratchets” ­ This  protects against equity dilution of additional  rounds of financing in “down­rounds”.

• This preferential treatment comes at the  expense of all common shareholders.

• If company does well, VC enjoys upside  provision by having right to put additional  money at a set price using warrants or 

options.

• Limiting risk by co­investing with other firms  known as “syndicating”.

Optimistic Investment Timeline

0 Entrepreneur identifies VC’s with appropriate match to needs 2­4 Entrepreneur gains personal introduction to a partner(s)

2­6 Entrepreneur has first telephone call, sends executive summary 4­6 Additional telephone calls, and exchange of business plan

6­8 Invitation to first presentation 8­12 Invitation to a full partners’ meeting presentation and discussions 10­16 Negotiation of Term Sheet, Signing of a Non­Disclosure Agreement 12­20 Due Diligence

16­24 Re­negotiation of Term Sheet, preparation of full legal documents 18­30 Closing and deposit of first tranche of investment funds

VC General Partnership(s)

Limited Partners

Copyright 2015 Jack M. Kaplan & Anthony C. Warren

Annual Management Fee = 2- 3%

Called Investment From Limited Partners

Individual Investments

•There are a number of federal and state restrictions that must

be met and you will need a securities lawyer to prepare the documents and make sure all the regulations are followed

•You should only offer shares to “accredited investors” who must meet certain requirements regarding personal net-worth and income history They must certify in writing that they are able to lose all their investment.

•The PPM must list all the risk factors in the investment

•There are private bankers that have networks of private investors that they advise You will need an introduction and you should check on references They take a fee for raising the agreed finance

• Up to $1,000,000

• 12  month completion period

• No restrictions on the number of  investorsRule 505

• Up to $5 million

• 12 month completion period

• No more than 35 non accredited investors and unlimited number of accredited investors

• In March, 2012, the so­called JOBS ACT  was signed into law

• As part of the bill, the requirements for  raising private equity from individuals were  relaxed in  to assist  Small Business Owners  and entrepreneurs to raise early stage money  and easier to go public more quickly.

• For the first time ever, members of the public  may invest in private startup companies 

• Having a large “crowd” of unknown  investors may bring management head­ aches when it is time to have a 

shareholders’ vote on key issues. 

• The chances of a frivolous shareholders’  law suit will increase.

• Intellectual Property may be  compromised

• In addition, if your company is highly  successful and needs more capital, 

institutional venture capitalists are  unlikely to fund a company with a 

“crowd” of shareholders for these reasons.

• One way to avoid this problem is to have  individuals invest via a “voting trust” 

whereby an independent trustee takes  actions on behalf of the shareholders.

acquire some debt financing from a  commercial bank

•At the early stages of a venture there are no historical financial performances on which to base a value using conventional 

accounting methods

•However, unless the founders decide to use convertible debt in the initial 1­2 investment rounds, a value must be agreed with an equity investor to determine what % of the company must be sold

Valuation Techniques  For Early Stage Ventures

• The business plan should have financial pro formas  for 5­7 years

•For the first 1­2 years the cash flow will be negative but thereafter it should be positive and growing

•The sum of these cash flows are discounted back to the present using a chosen internal rate of return or discount rate

•The earlier the stage of the company, the higher the risk is for an investor, and hence the discount rate will be higher too

•The minimum discount rate is 30% for an early stage company

• In addition investors are likely to reduce your estimated cash flows recognizing that companies rarely meet their financial targets in the early years. A factor of 2X reduction is typical

• The modified current value of future cash flows is the assumed current value of the company

Early Stage Valuation Discounted Cash Flow (DCF)

• This is often used by VC’s to determine their investment decision

•Investors can only receive a return on their investment when there is a LIQUIDITY event – the company is sold to another or there is an IPO

• Therefore the investor wishes to know what the company COULD be sold for, if it meets its goals, and WHEN

• Comparisons are sought for transactions where similar ventures have been sold ( COMPS)

•These values may be based on different metrics ­  P/E Ratios, Revenues, Growth, Gross Margins and Strategic Importance

• These SALE values are discounted back to the present using a 30% minimum discount rate, reduced for the risk level to get today’s value

• If the entrepreneur can argue that the sale could be strategic to a few competitors, the value is likely to be enhanced

Early Stage Valuation The Venture Capital Model

•The attainment of key milestones is often used

•One simple model is the Berkus model: 

Early Stage Valuation Milestone Methods