Copyright © 2008 by Nelson, a division of Thomson Canada Limited ENTREPRENEURSHIP A PROCESS PERSPECTIVE Robert A. Baron Scott A. Shane A. Rebecca Reuber Slides Prepared by: Sandra Malach, University of Calgary

Copyright © 2008 by Nelson, a division of Thomson Canada Limited 6 FINANCING NEW VENTURES 1

Copyright © 2008 by Nelson, a division of Thomson Canada Limited LEARNING OBJECTIVES 1.Explain why it is difficult for entrepreneurs to raise money from external investors. 2.Identify specific solutions to venture finance problems created by uncertainty and information asymmetry, and explain why these solutions work. 3.Explain why entrepreneurs typically raise very little start-up capital. 4.Create proforma financial statements and cash flow statements and conduct breakeven analysis.

Copyright © 2008 by Nelson, a division of Thomson Canada Limited LEARNING OBJECTIVES 5.Define debt and equity financing and explain how they differ. 6.Describe the different sources of capital for new ventures. 7.Describe the equity finance process from start to finish. 8.Explain why equity financing in new ventures is typically staged.

Copyright © 2008 by Nelson, a division of Thomson Canada Limited LEARNING OBJECTIVES 9.Describe how venture capitalists calculate the cost of the capital that they provide to new ventures. 10.Explain why direct and indirect social ties are important to raising money from external investors. 11.Identify the behaviours and actions that successful entrepreneurs engage in to encourage investors to back them, and explain why these behaviours and actions are effective.

Copyright © 2008 by Nelson, a division of Thomson Canada Limited INFORMATION ASYMMETRY PROBLEMS Entrepreneurs have information about their business that investors don’t have. This creates three problems: Investors must make decisions on limited information Entrepreneurs can take advantage of investors Adverse selection

Copyright © 2008 by Nelson, a division of Thomson Canada Limited UNCERTAINTY PROBLEMS Investors must make judgments based on little actual evidence Entrepreneurs and investors disagree on value of new venture Investors want collateral

Copyright © 2008 by Nelson, a division of Thomson Canada Limited SOLUTIONS TO VENTURE FINANCE PROBLEMS Self financing Contract provisions Covenants Convertible securities Forfeiture and anti-dilution Control rights Vesting periods

Copyright © 2008 by Nelson, a division of Thomson Canada Limited SOLUTIONS TO VENTURE FINANCE PROBLEMS Venture Capitalist Specialization By industry Be development stage Geographically localized investing Syndication

Copyright © 2008 by Nelson, a division of Thomson Canada Limited CAPITAL QUESTIONS How much money do I need? Where should I get that money? What type of arrangements do I need to make to obtain that capital?

Copyright © 2008 by Nelson, a division of Thomson Canada Limited START-UP CAPITAL How much do you need? Average Canadian business requires under $50,000 in startup capital. Asset based start-ups require higher start-up capital than hustle-based start- ups.

Copyright © 2008 by Nelson, a division of Thomson Canada Limited FINANCIAL ANALYSIS TOOLS List of startup costs and use of proceeds Proforma financial statements Cash flow statements Breakeven analysis

Copyright © 2008 by Nelson, a division of Thomson Canada Limited STARTUP COSTS All costs incurred to get the business off the ground Capital costs for equipment & long-term assets Working capital Determine the capital you need Determine what you’ll do with the capital once you get it

Copyright © 2008 by Nelson, a division of Thomson Canada Limited PROFORMA FINANCIAL STATEMENTS Project the financial condition of the new venture Estimate profit and loss (Income Statement) Cash Flow Statement Show financial structure of the business (Balance Sheet) Allow investors to conduct ratio analysis Performance Plus pp.nsf/en/Home pp.nsf/en/Home

Copyright © 2008 by Nelson, a division of Thomson Canada Limited INCOME STATEMENT Revenue – Expenses = Gross Income Revenue derived from accurate market analysis Expenses derived from costs Natural tendency to underestimate Industries have similar relationships

Copyright © 2008 by Nelson, a division of Thomson Canada Limited BALANCE SHEET Equity = Debit + Equity Illustrates the financial structure of the relationship

Copyright © 2008 by Nelson, a division of Thomson Canada Limited CIMITYM Cash is more important than your mother.

Copyright © 2008 by Nelson, a division of Thomson Canada Limited CASH FLOW Amount of cash on hand at a given point in time. Cash vs. accrual based accounting Cash inflows and outflows don’t always occur at the same time as revenue and expenses are incurred.

Copyright © 2008 by Nelson, a division of Thomson Canada Limited INCOME TO CASH FLOW Take your net profit and add back depreciation Subtract increases or add decreases in accounts receivable Subtract increases or add decreases in inventory Add increased or subtract decreases in accounts payable Subtract increases or add increases in notes/loans payable

Copyright © 2008 by Nelson, a division of Thomson Canada Limited IMPROVE THE FLOW Minimize accounts receivable Reduce the raw material and finished products inventory Control your spending Delay your accounts payable

Copyright © 2008 by Nelson, a division of Thomson Canada Limited BREAKEVEN ANALYSIS Calculate the amount of sales you need to achieve to cover your costs Determine the increase in sales volume you need to have in order to increase fixed costs Total fixed costs________________ (unit sales price - unit variable costs)

Copyright © 2008 by Nelson, a division of Thomson Canada Limited DEBT VS. EQUITY Debt—financial obligation to return capital provided plus a scheduled amount of interest Equity—The ownership of a company, which takes the form of stock. It also equals assets minus liabilities or net worth.

Copyright © 2008 by Nelson, a division of Thomson Canada Limited FINANCING WITH EQUITY New ventures tend to be financed by equity because: New ventures have no way to make scheduled interest payments until they have positive cash flow Debt financing at a fixed rate encourages people to take risky actions to increase profitability

Copyright © 2008 by Nelson, a division of Thomson Canada Limited DEBT FINANCING Debt guaranteed by the entrepreneur’s personal assets or earning power Asset-based financing Supplier credit

Copyright © 2008 by Nelson, a division of Thomson Canada Limited SOURCES OF CAPITAL Savings Friends and family Business angels Venture capitalists Corporations Banks Asset-based lenders Factors Government programs

Copyright © 2008 by Nelson, a division of Thomson Canada Limited SME FINANCING IN CANADA

Copyright © 2008 by Nelson, a division of Thomson Canada Limited CRITERIA FOR VENTURE CAPITALISTS Operate in high growth industry Have proprietary advantage Offer a product with a clear market need Be run by experienced management team Plan to go public

Copyright © 2008 by Nelson, a division of Thomson Canada Limited EQUITY FINANCE PROCESS 1.Referral of Entrepreneur to Venture Capitalist 2.Initial screening of Executive Summary 3.Review Business Plan 4.Due Diligence 5.Negotiate the Terms

Copyright © 2008 by Nelson, a division of Thomson Canada Limited THE OPTIMAL TEAM An excellent venture team with Motivation Passion Honesty Experience

Copyright © 2008 by Nelson, a division of Thomson Canada Limited THE OPTIMAL OPPORTUNITY An excellent business opportunity with Large market Appropriate strategy Compelling product description Externally observable competitive advantage

Copyright © 2008 by Nelson, a division of Thomson Canada Limited DUE DILIGENCE Investigation of The business The legal entity The financial records

Copyright © 2008 by Nelson, a division of Thomson Canada Limited STAGING OF FINANCING Staging of financing allows investors to Minimize their risk Gather more information over time Manage the uncertainty of investing

Copyright © 2008 by Nelson, a division of Thomson Canada Limited RATE OF RETURN The main factor that determines the rate of return for new venture financing The stage of venture development

Copyright © 2008 by Nelson, a division of Thomson Canada Limited RATES OF RETURN & FINANCING ROUNDS

Copyright © 2008 by Nelson, a division of Thomson Canada Limited VENTURE CAPITAL COST OF CAPITAL

Copyright © 2008 by Nelson, a division of Thomson Canada Limited ENCOURAGING INVESTORS Use impression management techniques Create a good story Create a sense of urgency Frame ideas to make them more appealing Prepare a good business plan

Copyright © 2008 by Nelson, a division of Thomson Canada Limited SOCIAL CAPITAL Investors are more likely to invest in entrepreneurs with whom they have a direct or indirect business or social tie. Entrepreneur will be less likely to take advantage of investor Ability of investor to invoke sanctions Efficient way to gather information Create positive attributions