Working with Funders1 Extra Notes: Working with Funders  Questions Answered –How is the value of a startup determined? –What are the steps involved in negotiating with investors? –What is an IPO? What process must an entrepreneur undertake to complete an IPO successfully?

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3 Equity Financing (Cont’d)  Venture Capital (VC) Community –VCs are in the business of finding companies with the potential for great growth and great economic return –Key Considerations VC funds are organized as limited partnerships looking for long-term (5-10 years) investments VC firms make money through a combination of profits on investment and fund management fees VC funds are created by a group of investors with a specific strategy for investment. The pool of money in the fund is fixed

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5 Valuation  Valuation is the art/science of trying to determine the worth of a company  Methods used in valuing a company –The Comparables Method Determine the worth of a company by comparing it to other similar companies The companies should be similar with respect to industry focus, income statement ratios, location, relations with suppliers, customer base, potential growth, growth rate and capital structure This method assumes that similar companies exist and that the information for comparison is available

Working with Funders6 Valuation (Cont’d) – The Financial Performance Method Uses a company’s earnings (or potential earnings) to project future cash flows and applies a discount rate to determine the Present Value (PV) of those cash flows The Discounted Cash Flow (DCF) is determined from –Performance Income Statements – Projections about the company’s future income statements are made based on growth assumptions for cost and revenues –Free Cash Flow – The amount of cash the company will have at its disposal is estimated based on the proforma income statement –Terminal Value – The expected value of the company at the end of the projected period is estimated. A discount rate is then applied to this value to estimate the present value of the company

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8 Valuation (Cont’d) – The Venture Capital Method VC’s use a hybrid valuation method, looking at both comparables and free cash flows To compensate for their high risk investments, VC’s apply a very large discount rate to estimate the company’s present value To compensate for future dilution, VC’s require a higher percentage ownership (for a given investment) based on an estimated retention ratio This valuation method is necessarily subjective –The Asset Valuation Method The company’s worth is determined from its current assets Because the majority of their assets are intangible, this method is generally not used for startups in the e-commerce industry

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10 Negotiations  Principles for Entrepreneurs –Investors want to know two things: What is the opportunity and why is this management team the best to pull it off –Guidelines for pitching an investment opportunity Know the audience Keep the presentation concise Talk about the management team  Term Sheet –A Term Sheet is a non-binding description of the proposed deal between the financier and the entrepreneur –The Term Sheet is analogous to a Letter of Intent (LOI) or Memorandum of Understanding (MOU)

Working with Funders11 Negotiations (Cont’d)  Securities –Types of Securities: The type of securities chosen by the company and the investor reflect the risk/reward appetite Zero Coupon Bonds - Upon maturity of this security, the investor redeems the initial investment and interest at a predetermined rate. This type of security provides ultimate protection to the investor Convertible Debentures – These securities are loans that are ‘converted’ into common stock (equity). The investor is considered to be a creditor until the company is past its high-risk stage Preferred Stock – This is the most commonly used security with VCs –Convertible Preferred –Redeemable Preferred –Participating Convertible Preferred Common Stock – Since they do not provide investors with any of the protections of the other securities, common stocks are rarely used by VCs

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Working with Funders13 Negotiations (Cont’d)  Rights and Privileges of Investors –Common rights that investors demand are Right of First Refusal – Investor has the right to meet any offer of outside financing in future investment rounds Preemptive Right – Investor has the right to maintain his percentage of ownership by investing additional funds in future investment rounds Redemption Rights – Investor has the right to achieve liquidity if the company has not been sold or undergone IPO within a predetermined time period Registration Rights – Investor has the right to demand that shares be registered, forcing the company into liquidity (public offering) Covenants – Terms designed to ensure that the money provided by the investor is used in a manner that is consistent with the agreement between the entrepreneur and investor Antidilution Provisions – Provisions that protect the investor from dilution in ownership that might occur in future round of financing

Working with Funders14 Negotiations (Cont’d)  Dilution –Dilution refers to the percent reduction in ownership that occurs whenever the company issues new shares of stock –While investors can protect themselves from dilution, founders are diluted with every round of financing –Two types of antidilution provisions to protect the investor Full Ratchet – Provides most protection to investor, but can be extremely punitive to entrepreneur Weighted Average – More fair to entrepreneur while still protecting the investor

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Working with Funders16 Exit (The Path to Liquidity)  Initial Public Offering (IPO) –Determining the Right Time for an IPO Asses if the company is ready for an IPO Asses if the market is ready to accept their offering –The IPO Process Selection of Underwriters – The underwriters are the bankers that will arrange for the purchase of stock for a commission Preparation of Registration Statement for SEC – Create prospectus outlining the company’s business and financial fundamentals Distribution of Preliminary Prospectus - or ‘Red Herring’ Preparation for and Completion of the Road Show – The company’s offering is presented directly to potential investors The Incorporation of SEC comments into the Registration Segment Agreement on a final share price and number of shares to be offered Close of the offering and distribution of the final prospectus

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Working with Funders19 Exit (Cont’d)  Mergers and Acquisitions (M&A) –M&A can often achieve the same goals as IPO (e.g. liquidity and increased valuation) with lower potential risk –In a Merger, two companies combine to achieve a financial and/or strategic objective, usually through the exchange of shares –In an Acquisition, one company buys another, usually with cash and/or stock –Analysts predict that M&A will become increasingly popular

Working with Funders20 Future of Capital Markets  Likely Trends of the post-new-economy boom era –A Return to Classic Venture Capitalism Investors will be more selective in their investments Investors will monitor their investments more actively Investors will diversify their portfolio across multiple industries The time to liquidity will be longer –A Shakeout of Both Funding Sources and Startups VC firms will select which companies to continue supporting and which to abandon Many of the smaller VC firms will be unable to recoup their losses and will disappear Angel investing will be curtailed

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Working with Funders22 Future of Capital Markets (Cont’d) –A Rougher, Tougher Breed of Entrepreneurs The balance of power in the VC community will shift back to the investor Startup valuations will be lower (more realistic) Individuals will take on the entrepreneurial challenge under more difficult conditions –Entrepreneurs Will Seek Other Sources of Liquidity Raising money from public will no longer be sure thing Acquisitions will become an increasingly desirable alternative for startups The value of these acquisitions will also decline as willing buyers become more scarce

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Working with Funders24 Future of Capital Markets (Cont’d)  Where Will the Investment Dollars Go in 2001? –VCs will be far more conservative than during the Internet boom –VCs will look for companies that are creative problem solvers –VCs will still have dollars to invest

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