Chapter 18 Financing Start-up and Growth
Copyright © Houghton Mifflin Company18-2 Overview Starting with a plan Financing start-ups Financing growth Valuing the business
Risk Points and Associated Funding Preparation for Start-Up Seed Capital Friends and Family Private Investors SBIR/STTR Early Stage Funding Private Investors Some Venture Capital Strategic Partners Late Stage Funding Venture Capital Public Equity Strategic Partners Revenues Manufacturing Risk Development Risk First Customer Marketing Risk Management Risk Initial Public Offering Year 1 Year 2Year 3
Copyright © Houghton Mifflin Company18-4 The Fundamental Truths About Raising Money
Copyright © Houghton Mifflin Company18-5 1: Raising Capital Takes twice as long as projected Investors identified may not work out Second-round may request buyout Significant costs to raising capital
Copyright © Houghton Mifflin Company18-6 Upfront Costs Financials Consultant CPA/Auditor I-Banker Marketing Costs Prospectus Legal Printing Back-end Costs I-Banking Legal Brokerage Easily up to $200,000 2: Cost of Raising Capital
Copyright © Houghton Mifflin Company18-7 3: Can You Impress Investors? Defensible competitive advantage? –Patented technology –Cycle time –Marketing, advertising, and sales force –Low cost manufacturing Customers? Experience? Growing market? Who are your friends?
Understanding the Funding Stages
Copyright © Houghton Mifflin Company18-9 Start with a Financing Strategy Look for smart money (who invests is more important than terms) Buy top management with first $$$ Get moving fast, early prototype with customer feedback Focus on one investor and get an intro Don’t marry your first date Go for the best deal, not the biggest
Copyright © Houghton Mifflin Company18-10 Financing the Start-up Entrepreneur resources –Savings, credit cards, mortgages, stock market accounts, friends and family Bootstrap –Hire as few employees as possible –Lease or share everything –Use other people’s money
Copyright © Houghton Mifflin Company18-11 Stage One: Bootstrapping in an Incubator Average incubee’s sales increased > 400% from time entered to time exited > Average annual growth in sales was $239,535 87% of grads still in business –Only 20% of new start-ups
Copyright © Houghton Mifflin Company18-12 Do Incubators Meet Needs? Higher order needs need to be met –Human network, access to expertise and capital, partnerships, professional resources, product design, first 100 customers Some negatives –Perception of being babied –Artificial buffer –Equity stake by incubator
Copyright © Houghton Mifflin Company18-13 Stage One: Private Investor “Angel” Profile Educated white males—40s/50s Net worth over $750k Used to be entrepreneurs First stage financing and young firms Invest near home—involved One to two deals a year Invest between $10,000 and $500,000
Copyright © Houghton Mifflin Company18-14 More on Angels 3 to 10 year time frame for ROI 5–10 times their investment, function of risk Find deals through referrals from business associates Make decisions more quickly Requirements for due diligence may be lower
Copyright © Houghton Mifflin Company18-15 MORE on Angels Order of investment interest –Manufacturing—industrial/commercial –Manufacturing—consumer –Energy/natural resources –Services –Retail/wholesale
Copyright © Houghton Mifflin Company18-16 An Unlikely Angel Investment A “me too” type of product No intellectual property Business location more than 100 miles away Mature or fading industry Return on investment less than 15 percent Not enough market research with customer Weak competitive analysis
Copyright © Houghton Mifflin Company18-17 An Unlikely Angel Investment (cont.) A poorly defined vision for the company No management team, a solo entrepreneur Weak management team with no experience Exit time more than 7 years away Unfamiliar business or industry Minority position with no voting rights Too many co-investors
Copyright © Houghton Mifflin Company18-18 What Winning Angels Do Consider the source carefully Focus on the model, not the plan Emphasize the entrepreneur and the team Seek a scalable business Look for the exit Identify the unfair advantage Focus on deals where they know something
Copyright © Houghton Mifflin Company18-19 Stage One/Two: Private Placement Raising capital from private investors –Securities: common/preferred stock, notes, bonds, debentures, limited partnership shares, etc. Reg D –Sophisticated investors –Blue Sky laws
Copyright © Houghton Mifflin Company18-20 Private Placement Advantages –Less costly, less time consuming than IPO –Availability of standardized offering statements –Don’t have to file with SEC
Copyright © Houghton Mifflin Company18-21 Alternative Sources Strategic alliances –R&D limited partnership –Joint venture Small Business Investment Company (SBIC) SBIR Grants –Phase I: develop concept and test feasibility –Phase II: pursue the innovation and develop the product –Phase III: commercialize the technology
Copyright © Houghton Mifflin Company18-22 Debt Sources Commercial banks Commercial finance companies Small business administration State-funded venture capital Incubators Customers and suppliers
Copyright © Houghton Mifflin Company18-23 Venture Capital Less than 1% of the 300K companies growing 20%+ per year are backed by VCs
Copyright © Houghton Mifflin Company18-24 Venture Capital Terms: Basic Principles VC gets money back first Participation in upside Control over fundamental events Creation of path to liquidity Preferred stock is the investment security of choice
Copyright © Houghton Mifflin Company18-25 Capital Structure Investment deal has –Amount of money to be invested –Timing and use of investment moneys –Return on investment to investors –Level of risk involved Preferred stock or debentures
Copyright © Houghton Mifflin Company18-26 Rules for Dealing with VCs Know your enemy Don’t shop the business plan Approach through a referral Write a killer executive summary Check out the terms sheet carefully Be patient Be prepared for a staged investment
Copyright © Houghton Mifflin Company18-27 What VCs Relate to Location can matter Growth track: bigger is better 10X investment in 5 years 25–50% per year PE = 15:1 or more
Copyright © Houghton Mifflin Company18-28 What VCs Relate to (cont.) Planned exit—make it short New paradigm, lead products Number of co-investors Bridge financing to position for an IPO Board seats
Copyright © Houghton Mifflin Company18-29 Ownership Stage 1: give up 30% + for every $1M Stages 2–3: give up 8–15% per $1M Stages 4,5,6: give up 5–6%
Copyright © Houghton Mifflin Company18-30 Your Due Diligence on the VC Identify your dream teams Don’t accept a term sheet before due diligence. Stay in control Request 5 references from each VC
Copyright © Houghton Mifflin Company18-31 Your Due Diligence on the VC (cont.) Interview references –Why did you choose this firm? –How effective have they been in securing deals and partnerships? –How effective have they been in recruiting board members? –How have they helped your company increase its valuation? –On a scale of 1–5, how would you rate the contact partner?
Copyright © Houghton Mifflin Company18-32 The Initial Public Offering (IPO)
The IPO Process
Copyright © Houghton Mifflin Company18-34 Advantages of Going Public Source of interest-free growth capital More prestige and clout Easier to form alliances and negotiate deals Public stock used to attract employees and reward existing employees
Copyright © Houghton Mifflin Company18-35 Disadvantages of Going Public Expensive process: $300,000+ Time-consuming Company information is public CEO responsible to shareholders Entrepreneur may not control stock Pressure to perform in the short term SEC reporting requirements
Copyright © Houghton Mifflin Company18-36 Of 3,186 firms that went public in 1980s, only 58 percent still listed on one of three major exchanges
Copyright © Houghton Mifflin Company18-37 The stock of only one third of these firms was selling above issue price
Development Seed & Early StageGrowth & Harvest R&D Break-even Profitable, Needs Expansion Capital Buyout, Merger, IPO Direct Offerings Warrants Common Stock First Customer Multiple Customers Multiple Products May 2002Nov 2002June 2003Sept 2005 Notes Bonds Debentures Common Stock Preferred Stock Direct Offerings Sept 2003 Direct Offerings Warrants Notes Common Stock Preferred Stock Debentures Major Financing Instruments at Different Milestones
Copyright © Houghton Mifflin Company18-39 Valuing the Business Fair market value: willing seller and buyer Intrinsic value: interpreting balance sheet and income statements Investment value: worth to an investor Going concern value: current financial status Liquidation value: amount recover from sale of assets Book value: accounting measure that is the difference between total assets and total liability
Copyright © Houghton Mifflin Company18-40 Valuation Methods Multiple of earnings –Market price of common stock/earnings per share Discounted Cash Flow Analysis –How much an investor would pay today to have a cash flow stream of X dollars for X number of years into the future
Copyright © Houghton Mifflin Company18-41 Other Factors in Valuation The assumptions used to estimate value The degree of legitimate control the owner has in the business Intangibles like a loyal customer list and intellectual property The bottom line: Negotiation determines the value
Copyright © Houghton Mifflin Company18-42 Summary Plan financing stages carefully Use friendly money first Stick with private placement as long as possible Do YOUR due diligence Get references Be proactive
Copyright © Houghton Mifflin Company18-43 Take-Aways List what students took away from the discussion in real time