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Entrepreneurs view the need for and the ownership of resources differently than managers in large organizations. Howard H. Stevenson notes that entrepreneurs seek to use the minimum possible amount of all types of resources at each stage in their venture growth. By controlling resources, instead of owning them, entrepreneurs reduce some of the risk, including staged capital commitments, less capital, more flexibility, low sunk cost, lower costs, and reduced risk.
Minimizing resources is referred to as bootstrapping, or as a lack of resource intensity. According to Greg Gianforte, founder of a software company, Brightwork Development Inc., lack of money is actually a huge advantage because it forces the bootstrapper to concentrate on selling to bring cash into the business. Managers in large institution seek to have not only enough committed resources for the task but also a cushion against the tough times.
Successful ventures obtain the use of other people’s resources. Having the use of the resource and being able to control or influence the deployment of the resource is key. These resources include money invested or lent by friends, relatives, business associates, or other investors. Other resources, such as people, space, equipment, or other material may be provided inexpensively or free by customers or suppliers, or secured by bartering future services, opportunities, and the like. Other ways to minimize the resources owned include employing professional expertise on a project basis and leasing rather than owning expensive equipment.
The Internet provides one very important resource: information. Industry statistics, management articles, vendor information, and the like is available on-line and up-to-date. These are resources that would have taken earlier entrepreneurs weeks or months to put together.
The Internet also helps the entrepreneur build and maintain a network of contacts. Experts advise entrepreneurs to seek out the best advisors and involve them thoroughly. E-mail and instant messaging provide instant access to critical advice from your brain trust.
In choosing a board of directors, it is important to select trustworthy people. It is also important to find the right people to fill the gaps in the management team. Entrepreneurs seem to value operating experience over financial expertise. The best directors are willing to devote significant time to the new venture.
In choosing a lawyer, most entrepreneurs say personal contact with a member of the firm is the main decision criteria, followed by reputation and prior relationship with the firm. Size is also a consideration. Big firms have a wider expertise base, but the small venture may be not receive individual attention. For a small venture, smaller firms may be more appropriate. The chemistry between the entrepreneur and the lawyers is also important.
An entrepreneur should carefully pick the right banker or lender rather than to pick just a bank. Ideally, an entrepreneur needs an excellent banker or lender with an excellent financial institution. An excellent banker or lender with a just OK institution is preferable to a just OK banker with an excellent institution.
In choosing accountants, the first step is to decide whether to go with a smaller local firm, a regional firm, or one of the major accounting firms. Other selection criteria include level of service offered, current and future needs, cost, and chemistry.
The number of people calling themselves “management consultants” is large and growing. Many work on their own, while the remainder works for firms. A key decision is whether to use consultants with government agencies, such as the Small Business Administration, private or nonprofit organizations, or professionals that provide consulting services part-time. The right chemistry is again critical. Consultants tend to have specialties, so the entrepreneur should choose the appropriate specialist. Other considerations are cost, professional affiliations, and good references.
Ch. 12 - Define the following and explain why they are important: burn rate, free cash flow, fume date, time to clear, and financial management myopia.
Many entrepreneurs overemphasize financing. The opportunity leads and drives the business strategy, which in turn drives the financial requirements, the sources and deal structures, and the financial strategy. Financing flows from opportunity, not the other way around.
On the other hand, a business must make money in order to survive. More specifically, cash flow and cash are kind and queen in entrepreneurial finance. The venture must carefully analyze various fund-raising strategies in order to achieve its goals.
Critical variables affecting the availability of various types of financing, their suitability and cost, including: (1) accomplishments and performance to date; (2) investor’s perceived risk; (3) industry and technology; (4) venture upside potential and anticipated exit timing; (5) venture
anticipated growth rate; (6) venture age and state of development; (7) investor’s required rate of return or internal rate of return; (8) amount of capital required and prior valuations of the venture; (9) founders’ goals regarding growth, control, liquidity, and harvesting; (10) relative bargaining positions; and (11) investor’s required terms and covenants.
Free cash flow is defined as:
Earnings before interest and taxes (EBIT)
Less Tax exposure
Plus Depreciation, amortization, and other noncash charges.
Less Increase in operating working capital
Less Capital expenditures.
The free cash flow affects the venture’s OOC (when the company will be out of cash) and the TTC (or time to close the financing.) These impact the entrepreneur’s choices and relative bargaining power with various sources of equity and debt capital.
Valuation of a company is the value that capital markets place on the venture (number of shares outstanding times share price.)
Due diligence is the process by which the potential investor verifies the capabilities of the venture, the backgrounds of the management team, and technical specifications of the product.
IPO stands for initial public offering, the process by which a company raises capital through federally registered and underwritten sales of the company’s shares.
Mezzanine financing refers to capital that is between senior debt financing and common stock, usually subordinated debt with an equity element.
SBIC stands for Small Business Investment Companies, firms licensed by the SBA to provide debt capital to small emerging enterprises in exchange for equity.
Private placements are an alternative to going public; the venture sells shares of its stock to a small group of investors rather than to the public as a public offering.
Regulation D was developed through the cooperation of the SEC and the state securities associations to provide a uniform exemption from registration for small issuers.
Rule 504: Issuers that are not subject to the reporting obligations of the Securities Exchange Act and that are not investment companies may sell up to $1 million worth of securities over a 12-month period to an unlimited number of investors.
Rule 505: Issuers that are not investment companies may sell up to $5 million worth of securities over a 12-month period to no more than 35 non-accredited purchasers and to an unlimited number of accredited investors.
Rule 506: Issuers may sell an unlimited number of securities to no more than 35 unaccredited but sophisticated purchasers, and to an unlimited number of accredited purchasers.
ESOP stands for employee stock ownership plans in which the employees become investors in the company, thereby creating an internal source of funding.
Potential investors will want to talk with a venture’s directors, advisors, former bosses, and previous partners. The firm should provide very detailed resumes and lists of 10 to 20 references such as former customers, bankers, vendors, and so on. They should also prepare extra copies of published articles, reports, studies, market research, contracts, purchase orders, technical specifications, and the like.
Scarcity of capital leads to high returns, which attracts an overabundance of new capital, which drives returns down. The venture capital investment cycle repeats itself.
Venture capital firms stay away from seed and early-stage investments because those deals tend to require relatively small amounts of capital, and the megafunds like to make larger commitments. They have a large fund of capital which needs to be invested. There are fewer large high-growth, high potential ventures than small high–potential ventures. The venture capital available competes for the bigger superdeals.
Entrepreneurial ventures have many potential sources of capital. The best source for the entrepreneur is bootstrapping financing, finding creative ways to conserve the founders’ capital. Angel investors, wealthy individuals seeking to invest in high-growth potential firms, can be located through the Internet, through one’s own network of contacts, and through referrals from professionals such as lawyers, accountants, and current investors.
Venture capital funds provide funding for entrepreneurs in businesses with high growth potential. Guides such as Pratt’s Guide to Venture Capital Sources and Ventureone’s Web site can identify potential venture capital investors. Entrepreneurs can also seek referrals from accountants, lawyers, investment and commercial bankers, and knowledgeable businesspeople.Other sources include the Small Business Administration’s 7(a) Guaranteed Business Loan Program, Small Business Investment Companies, mezzanine capital, private placements, initial public stock offerings, private placements, and employee stock ownership plans (ESOPs.)
The various capital sources have preferences as to the stage of the venture’s development, the amount of capital they provide, and the portion of the company and share price expected from the eventual initial public offering. At the R&D stage—when the company has a valuation of less than $1 million—ventures are limited to capital from founders; angels; friends, family, and fools; and SBIRs. The earlier the capital enters, the more costly it is. By the time the venture reaches high growth, more sources and more capital is available.
At IPO the capital markets are typically willing to pay $12 to $18 per share. Share prices are lower during tight IPO periods, as low as $5 to $9. In hot IPO periods, share prices can be over $20. Founders have to decide whether to give up equity in order to create very significant value. If founders have to give up 70 percent to 80 percent of equity, the market capitalization must be at least $100 million to create significant value.
The peak capitalizations during the 1990s were not sustainable. In the recent venture capital food chain, the amount of capital invested is quite substantial.
The ingredients to the entrepreneurial valuation are cash, time, and risk. The amount of cash available and the cash generated play an important role in valuation. Timing of the deal plays an influential role. Finally, risk or perception of risk contributes to the determination of value. “The greater the risk, the greater the reward” plays a role in how investors value the venture.
Long-term value creation means building the best company possible. This is the core mission of the entrepreneur. Creating value for the long-run is very different from simply maximizing quarterly earnings to attain the highest share price possible.
IRR is the annual rate of return that venture capital investors seek on investments. The required ROR is a function of premium for systemic risk, illiquidity, value added, stage of development, and amount of capital invested.
Investor’s required share of ownership is the percentage of the venture which the investor seeks to obtain. This involves computing the future value of the company. The rate of return required determines the investor’s required share.
DCF is the discounted cash flow, based on three time frames. This is calculated by using initial sales, growth rates, EBIAT, and working capital in each time period. The discount rate can be applied to the weighted average cost of capital. Then the value for free cash flow is added to the terminal value.
Deal structure is the set of negotiated agreements between investor and entrepreneur. Most deals involve the allocation of cash flow streams, the allocation of risk, and allocation of value between the different groups. The deal includes value distribution, basic definitions, assumptions, performance incentives, rights, and obligations.
Sand traps in fund-raising are the pitfalls a venture can fall into when trying to obtain financing. These include strategic circumference, legal circumference, attraction to status and size, unknown territory, opportunity cost, underestimation of other costs, greed, being too anxious, impatience, and take-the-money-and-run myopia.
Ch. 14 - Explain five prevalent methods used in valuing a company and their strengths and weaknesses, given their underlying assumptions.
The venture capital method is appropriate for investments in a company with negative cash flows at the time of the investment, but which anticipates significant earnings in a number of years. Venture capitalists are the most likely investors to participate in this type of investment. The steps involved are:
(1) Estimate the company’s net income in a number of years.
(2) Determine the appropriate price-to-earnings ratio, or P/E ratio.
(3) Calculate the projected terminal value by multiplying net income and the P/E ratio.
(4) The terminal value can then be discounted to find the present value of the investment.
(5) To determine the investor’s required percentage of ownership, the initial investment is divided by the estimated present value.
(6) Finally, the number of shares and the share price must be calculated.
This method is commonly used by venture capitalists because they make equity investments in industries often requiring a large initial investment with significant projected revenues. The percentage of ownership is a key issue in the negotiations.
The fundamental method is simply the present value of the future earnings stream.
The First Chicago Method, developed at First Chicago Corporation’s venture capital group, employs a lower discount rate, but applies it to an expected cash flow. That expected cash flow is the average of three possible scenarios, with each scenario weighted according to its perceived probability. The formula is presented in Text Exhibit 14-8. This formula differs in two ways:
(1) The basic formula assumes there are no cash flows between the investment and the harvest.
(2) The basic formula does not distinguish between the forecast terminal value and the expected terminal value.
The traditional method uses the forecast terminal value, which is adjusted through the use of a high discount rate.
The ownership dilution method considers the discount rates that are most likely to be applied in succeeding rounds. The previous valuation example is unrealistic because several rounds of investments are necessary to finance a high-potential venture. As illustrated in Text Exhibit 14.9, three stages of financing are expected. In addition to estimating the appropriate discount rate for the current round, the first round venture capitalist must now estimate the discount rates that are most likely to be applied in the following rounds. The final ownership that each investor must be left with, given a terminal price/earnings ratio of 15, can be calculated using the basic valuation formula.
In a simple discounted cash flow method, three periods are defined: Years 1-5. Years 6-10, and Year 11 to infinity. The necessary operating assumptions are initial sales, growth rates, EBIAT/sales, and (net fixed assets + operating working capital)/sales. Using this method, one should also note relationships and trade-offs. The discount rate can be applied to the weighted average cost of capital (WACC.) Then the value for free cash flow (Years 1-10) is added to the terminal value.
There are other valuation methods based on similar, most recent transactions of similar firms. Venture capitalists know the activity in the current marketplace for private capital. These methods are used most often to value an existing company rather than a startup.
Venture capitalists will rarely, if ever, invest all the external capital that a company will require to accomplish its business plan; instead, they invest in companies at distinct stages in their development. By staging capital, the venture capitalists preserve the right to abandon a project whose prospects look dim. Staging the capital also provides incentives for the management team.
A company evolves from its idea stage through an initial public offering (IPO.) The appetite of various sources of capital varies by company size, stage, and amount of money invested. In the theory of company pricing, a venture capital investor envisions two to three rounds. The per share equivalent increases with each round: four to five times markup to Series B, followed by a double markup to Series B, then again by double markup to Series C.
In reality, current market conditions, deal flow, and relative bargaining power influence the actual deal struck. Changes in the overall market can radically impact the valuation of a company. During the dot.com bubble from 1998 to early 2000, the valuations became extreme—some companies were valued at 10 times revenue. When the collapse came, even strongly performing companies saw their valuations plummet. In this environment, the price per share of ventures may actually decline in the second round of financing, diluting the founder’s ownership.
Ventures typically go through three to four rounds of financing from idea stage to initial public offering. In theory, the per share equivalent increases with each round: four to five times markup to Series B, followed by a double markup to Series B, then again by double markup to Series C. In reality entrepreneurs face rude shocks in the second or third round of financing. Instead of a substantial four or even five times increase in the valuation from Series A to B, or B to C, they are jolted with a “cram down” round, in which the price is typically one-fourth to two-thirds of the last round.
There are several inherent conflicts between entrepreneurs, or the users of capital, and the investors, or the suppliers of capital. The entrepreneur wants to have as much time as possible for the financing, while the investors want to supply capital just in time.
Users of capital want to raise as much money as possible, while the investors want to supply just enough capital in staged commitments. In the negotiations of a deal, each side balances capital and deal terms.
The styles of providers and users of capital differ. The users value their independence and treasure the flexibility their own venture has brought them. However, the investors are hoping to preserve their options, including reinvesting and abandoning the venture.
There are also clashes in the composition of the board of directors. The entrepreneur seeks control and independence. The investors want the right to control the board if the company does not perform as well as expected.
The long-term goals of the users and suppliers of capital may also be contradictory. The entrepreneurs may be content with the progress of their venture and happy with a single or double. The investors will not be quite as content with moderate success, but instead want their capital to produce extraordinary gains.
Management styles also differ. The entrepreneur is willing to take a calculated risk or is working to minimize or avoid unnecessary risks. The investor is willing to accept higher risks for higher return.
Entrepreneurs see opportunities and seize those opportunities. Investors are looking for clear steady progress.
The ultimate goals may differ, also. The entrepreneur views success as a process of long-term company building. The investors will want to cash out in two to five years.
Most deals involve the allocation of cash flow steams, the allocation of risk, and the allocation of value between different groups. To design long-lived deals, Professor William A. Sahlman from Harvard Business School suggests using a series of questions as a guideline for structuring deals. These questions include: Who are the players? What are their goals and objectives? What risks do they perceive and how have these risks been managed? What problems do they perceive? How much do they have invested? What is the context surrounding the current decision? What is the form of their current investment or claim on the company? What power do they have to act? To precipitate change? What real options do they have? What credible threats do they have? How and from whom do they get information? What will be the value of their claim under different scenarios? How can they get value from their claims? To what degree can they appropriate value from another party? How much uncertainty characterizes the situation? What are the rules of the game? What is the context at the current time?
Far more is negotiable than entrepreneurs think. The “boilerplate” investors use may not be fixed in concrete. It is possible for an entrepreneur to negotiate and craft an agreement that represents his or her needs. A successful negotiation is one in which both sides believe they have made a fair deal.
The primary focus is likely to be on how much the entrepreneur’s equity is worth and how much is to be purchased by the investor’s investment. Other issues involving legal and financial control of the company and the rights and obligations of investors and entrepreneurs. Another issue is the value behind the money that a particular investor can bring to the venture. Many of the tools for managing risk/reward also apply.
Subtle but highly significant issues may be negotiated, including co-sale provision, ratchet anti-dilution protection, washout financing, forced buyout, demand registration rights, piggyback registration, and key-person insurance.
The entrepreneur encounters numerous strategic, legal, and other “sand traps” during the fund-raising cycle and needs awareness and skill in coping with them. Some of these sand traps include:
Strategic circumference. Each fund-raising strategy causes actions and commitments that will eventually scribe a strategic circumference around the company. The entrepreneur needs to think through the consequences of each fund-raising strategy. Scribing a strategic circumference may be intentional, or may be unintended and unexpected.
Legal circumference. Legal documentation spells out the terms, conditions, responsibilities, and rights of the parties to a transaction. Because these details come at the end of the fund-raising process, an entrepreneur may arrive at a point of no return. To avoid this trap, entrepreneurs need to sweat the details. It is very risky for an entrepreneur not to carefully read final documents and to use a lawyer who is not experienced and competent.
Attraction to status and size. Simply targeting the largest or the best-known firms is a trap entrepreneurs often fall into. Such firms may or may not be a good fit. It is best to focus your efforts toward financial backers, whether debt or equity, who have intimate knowledge and experience in the competitive area.
Unknown territory. Entrepreneurs need to know the terrain, particularly the requirements and alternatives of various equity sources. A venture that is not a “mainstream venture capital deal” may be overvalued and directed to investors who are not a realistic match.
Opportunity cost. An entrepreneur’s optimism can lead to grossly underestimating the real costs of getting the cash in the bank. They also underestimate the real time, effort, and creative energy required. There are opportunity costs in expending these resources in a particular direction when both the clock and the calendar are moving. In the months it takes to develop a capital source, cash and human capital might have been better spent elsewhere. It is common for top management to devote as much as half of its time trying to raise a major amount of outside capital. Significant opportunity costs are also incurred in forgone business and market opportunities.
Underestimation of other costs. Entrepreneurs tend to underestimate the out-of-pocket costs associated with both raising money and living with it. The Securities and Exchange Commission requires regular audited financial statements. There are also outside directors’ fees and liability insurance premiums, legal fees, and so on. Another “cost” is of the disclosure that may be necessary to secure a backer.
Greed: The entrepreneur may find the money irresistible.
Being too anxious. Another trap is believing that the deal is done and terminating discussions with others too soon. Entrepreneurs want to believe the deal is done with a handshake. The entrepreneur may need to create an illusion of multiple financing options.Impatience. Another trap is being impatient when an investor does not understand quickly. If the entrepreneur becomes too impatient, they expose themselves to additional risk
Sources of debt financing are the various methods of obtaining borrowed capital. The sources differ for a startup company and an existing company and differ in term of financing.
Trade credit is the financing available from suppliers. If a business is able to buy goods and services and be given 30, 60, or 90 days to pay, that business has essentially obtained a loan for that period.
A line of credit is a formal or informal agreement between a bank and a borrower concerning the maximum loan a bank will allow the borrower for a one-year period. Lines of credit are used for seasonal financings such as inventory buildup and receivable financing.
Accounts receivable financing is also known as factoring. In this form, accounts receivables are sold, at a discounted value, to a factor. Factoring can make it possible for a company to secure a loan that it might not otherwise get.
Time-sales finance occurs when dealers or manufacturers who offer installment payment to purchasers of their equipment sell and assign the installment contract to a bank or sales finance company. The manufacturer gets short-term financing from long-term installment accounts receivable, and the purchaser gets financing for the purchase of new equipment.
A commercial finance company is an institution that loans money to companies that do not have a positive cash flow, but are otherwise viable credit risks. They lend against the liquidation value of assets. Commercial finance companies provide loans to companies that are unable to borrow from banks.
The amount of capital available depends on the assets on the balance sheet. The percentage of value available from accounts receivable is 70 to 85 percent; for inventory, 20 to 70 percent; for equipment, 70 to 80 percent; for a chattel mortgage, 80 percent of auction value; for conditional sales contract, 60 to 70 percent; and for plant improvement loans, 60 to 80 percent.
A good lender relationship can be important to the company, especially in difficult times. Entrepreneurs should also look for a bank with knowledge, sense of urgency, teaching talent, industry knowledge, financial stability, and a manager with backbone. Some banks have one or more high-technology lending officers who specialize in making loans to early-stage, high-technology ventures. Finally, the bank should be big enough to service a venture’s foreseeable loans but not so large as to be relatively indifferent to the business.
In centers of high technology and venture capital, the main officers of the major banks will have one or more high-technology lending officers who specialize in making loans to early-stage, high-technology ventures. These bankers have come to understand the market and operating idiosyncrasies, problems, and opportunities of such ventures. They have close ties to venture capital firms and will refer entrepreneurs to such firms for possible equity financing.
The most important criteria are the quality and track record of the management team. Historical financial statements, which show three to five years of profitability, are also essential. The bank considers the available collateral and of debt capacity determined by analysis of the coverage ratio.
Once the company gets into serious financial trouble, restructuring of debt is often part of the survival and recovery plan. If the lenders forgive the principal and interest in exchange for warrants, direct equity, or other considerations, the forgiven debt becomes taxable income for the entrepreneur who owns the company and who has personally had to guarantee the loans. Overleveraged entrepreneurs have been hit with huge tax bills.
To build credibility with bankers, entrepreneurs should borrow before they need to and then repay the loan. This will establish a track record of borrowing and reliable repayment.
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