Entrepreneurship & Small Business Management Frank Moyes Leeds School of Business University of Colorado Boulder, Colorado Funding

Today’s Agenda Funding Sources Bank debt Visitors: Jay Thompson and Pat O’Brien of Wells Fargo Bank Valuation Entrepreneurship interviews Funding

Next Week Marshalling Resources Strategic Alliances Jurismonitor case Speaker: David Hunter CEO of Encrypt Corporation Deal structure: David Kendal, attorney Funding

How Are Going to Fund Your New Venture? Personal Resources Friends & family Debt Equity Grants Non-traditional Funding

Personal Resources Sources Personal Resources Sources Savings Mortgage on house Credit cards Skin in the game – best indicator of commitment Advantages Prove the concept Establishes value before go to outside investors Disadvantages Pressures on family People who love you Funding

Friends & Family Easy negotiation Need formal agreement Advantages Maintain control Disadvantages Unsophisticated investors Different kind of obligation Auntie Em’s life savings Turn a good friend to an enemy? Things will go wrong Funding

Equity Sources Advantage Disadvantages F & F Angels Private Placement Equity Sources F & F Angels Private Placement Venture Capital Corporate venture subsidiaries IPO (Initial Public Offering) Advantage Permanent capital Disadvantages Give up piece of company (dilution) Responsibilities to investor Exit for investor – achieve a return Funding

Debt Banks SBA Credit unions, S & L’s Debt Banks SBA Credit unions, S & L’s Factoring receivables & inventory Commercial financing co Commercial Finance companies Mezzanine Sits on balance sheet between debt and equity Debt, but doesn't have to be repaid right away Equity, warrants Guido Lender will ask How will use loan? How much need? How repay? Funding

Debt Advantages Disadvantages No dilution Debt Advantages No dilution Disadvantages Very difficult to obtain in early stages Must pay back Interest expense Personal guarantee Lack of value-add money Funding

Borrowing from Banks Types of loans How banks look at borrowers? How do you approach a bank? Personality of a bank SBA Loans Funding

Types of Bank Loans Short term loans Term loans Secured and unsecured One time Line of credit Term loans Monthly installments Balloon Secured and unsecured Funding

How Banks Look at Borrowers? Attitude toward risk 4 C’s: credit history, character, capacity, collateral How are you going to repay it? Not: “If I default, there are assets to cover it.” Banks don’t like work out situations Cash flow loans and Realizable assets Accounts Receivable Inventory Personal guarantees Funding

How Do You Approach a Bank? Establish a good credit history Borrow when you don’t need it Business Plan Costs & fees Loan processing fee Interest rates Services provided Funding

Personality of a Bank Banks have different policies Big company or small company Aggressive or cautious New companies or established How important are relationships? Shop around – new customers seem to get better deals than existing Keep them informed of how your business is doing – no surprises Funding

Small Business Administration (SBA) Loans Loan made by a bank, but guaranteed by the feds What are the criteria for receiving a SBA loan? How differ from a traditional bank loan? Fees Interest rates Funding

Equity Sources Advantage Disadvantages F & F Angels Private Placement Equity Sources F & F Angels Private Placement Venture Capital Corporate venture subs IPO (Initial Public Offering) Advantage Permanent capital Disadvantages Give up piece of company (dilution) Responsibilities to investor Exit for investor – achieve a return Funding

Angels Sophisticated investor who invests in early stage companies 250,000 + angels in US Invest $5 bill - $10 Bil, 20K – 30K companies annually Typical investment = $25K - $250K High net worth individuals Usually wants to invest in industry where has experience Accessing Angels Not in the Yellow Pages Networking ACE-net.org Funding

Angels (cont’d) Advantages Disadvantages Early stage resource Angels (cont’d) Advantages Early stage resource Value-added money : network, advice, commitment Disadvantages No follow-on funds Give-up equity Over-control from angel Funding

Venture Capital Overview Advantages Disadvantages Venture Capital Overview $40 Bil in 2003; 3,000-3,500 investments Partnership: limited & general Advantages Greatest value-added money Consulting, mentoring, network Validation of your concept Disadvantages Loss of equity, maybe control. But, achieve your dream Must have common objectives Exit strategy Why people want to be VC’s Funding

Venture Capital Required Rates of Return ROI Increase Seed 60%+ 10x+ Start-Up 50% 8x Early Stage 40% 5x Second Stage 30% 4x Exit 25% 3x Funding

Private Placement Private offering to a focused group of investors Accredited investors SEC & Blue Sky Laws apply If less than $1 million, then any number of small investors Sam Adams Advantages Quicker & less expensive than IPO SEC regulations are not as onerous Disadvantages Give up equity Lack of advice / mentoring Can be complicated, expensive & take a lot of time Minority investors Funding

What do Investors Look For? Management team Experience Expertise in industry Passion Commitment of CEO Market potential: size & growth Stage of development Scalable product or service Proprietary Profitability Acceptable valuation - return Funding

IPO Public offering to buy ownership in an organization Advantages Obtain cash for opportunities that would otherwise be unaffordable More capital with less stock dilution To achieve liquidity for owners and investors Disadvantages Costly and time consuming Change of leadership focus Funding

Grants State, regional and municipal development agencies CapCo Federal SBIR (Small Business Innovation Research) CREDA (Cooperative Research & Development Agreement) Research – university & corps. Foundations freemoney.com Advantage: no equity or debt Disadvantage: Red tape and strings Grant mentality Funding

Non-traditional Funding Sources Customers Suppliers Joint ventures and strategic partners Leasing of equipment Broker/Promoters Microloans – banks & non-profits <$25,000 Incubators Equity for professional services Funding

Government SBA Loans SBIC’s – a “government VC” 450 in the US Backed by the SBA $13 bill since 1958 Small Business Development Centers – state and local organizations finance job creation Funding

What Methods Are Used To Value Entrepreneurial Ventures? What Methods Are Used To Value Entrepreneurial Ventures? Tangible book value P/E ratio Discounted cash flow is not a good method for valuing early stage companies! VC method (see Bygraves & Zacharakis) Financial projections Market comps for similar companies Multiple of earnings Multiple of sales Investor ROI Usually not a cash flow stream Pre-money & post money % of Board seats Funding

Risks Market Strategic Operational Technology Financial Macro-economic size of market competitors response sales cycle closing window of opportunity Strategic establishing strategic partnerships Operational large number of interrelated components Technology will it work time and cost to develop scalability Financial risk/return dilution Macro-economic volatile industry government approval Funding

How Assess Risk? Stage of Development Management Team Commitment of CEO Experience Knowledge of industry Make forecasts Proprietary Product or Service Market Profitability Valuation Take a step back You're the investor Market: Does anyone want to buy? Profitability: Can you make money? What kinds of returns are required? Funding

Stages of Development Mapped with Funding Seed (proof of concept) Personal Start-up (set-up production & sales) Angels PPO Early stage (full-scale operations & mkt) VC Government Funding

Stages of Development Mapped with Funding Stages of Development Mapped with Funding Second stage (expansion) VC Financial institutions Debt Reinvestment Exit (harvest) IPO Funding

Discount Rates Seed capital Second-stage financing Startup financing Discount Rates Seed capital 80 to 100% Startup financing 50 to 70% First-stage financing 40 to 60% Second-stage financing 30 to 50% Bridge financing 20 to 35% Restart financing variable Funding

Factors Affecting Discount Rates Factors Affecting Discount Rates Total Discount Rate Risk of failure adjustment Cash Flow Adjustment Value of VC advice Value Added Investment not liquid Justifiable Discount Rate Liquidity Market sensitivity Systematic Risk Risk-free investment Base Rate Seed Stage 1 Stage 2 Bridge IPO Funding Sahlman, A Method for Valuing High-Risk, Long-Term Investments, teaching note, HBS 9-288-006.