Managing Entrepreneurship and Innovation 4. Financing the Venture

Lecture contents This lecture will examine: Guiding principles: 4Fs & 3 forms of initial finance, scale, and capital & risk Sources of new venture finance: banks, business angels & venture capitalists What investors are looking for in a venture Structuring new venture finance: funding life cycle, control, risk & harvest

The 4 Fs of initial finance Initial investment usually arises from 4 Fs: 1.Founders’ own savings and assets 2.Family money and contributions 3.Friends’ money or assets 4.Foolhardy investors’ sums handed over as a result of silver-tongued persuasion!

Three forms of initial finance That start-up capital takes one of three main forms: 1.Personal savings – the simplest form, their own cash reserves or assets 2.Debt – borrowing from a lender, paying interest but retaining control 3.Equity – selling shares for capital, no interest but losing partial control

Scale at start-up USA Inc. magazine’s annual list of 500 star small businesses shows that: 25% began with under $5,000 50% began with under $25,000 75% began with under $100,000 Only 5% started with over $1 million So small contributions, savings & ‘sweat equity’ are vital to get going

Capital and risk The 2 nd, 3 rd & 4 th of 4Fs will expect returns: Supply and demand operate in the capital market as in any other market The price (cost) of capital depends on the expected rate of return The ERR is a function of both perceived risk & the opportunity cost of placing money with this venture, not another

Sources of new venture finance Beyond initial start-up, entrepreneurs often gain access to finance through: Banks Business angels Venture capital funds

Finance from banks Banks don’t like risk so demand tough searches & real collateral as security They want to see financial literacy & to be kept in touch with venture developments But debt finance has benefits when interest is written off against tax Building relations with bankers gives access to local & financial knowledge

The banker’s 5Cs A common banker’s checklist: Character of borrower Capacity to repay Conditions (product, industry, economy) Capital provided (debt/equity ratio) Collateral or security

Business angels Important ‘informal’ start-up investors, often wealthy & experienced ex-entrepreneurs: US, 250,000 angels investing $10bn. p.a. UK, 18,000 investing £500m. p.a. with an average deal of £57,000 US angels accept 32% p.a. return on avg. Over 80% take an active role in ventures

Venture capital funds Partnerships (e.g. Atlas) or VC funds (e.g. 3i) arrange & manage early-round funds: European VCs invested £7.8bn. in 1999, £6.1bn. to UK firms 50% in UK for management buy-outs/ins £1m.+ deals for early-round funding less involvement but higher & quicker returns (40%p.a.) than angels

What investors are looking for product/market info. & size, growth rates strategic/competitive dynamics & barriers management team, leadership capabilities management competence & ability financials, time to break-even & return rate fund portfolio & relevance to fund strategy deal structure & stage of investment

Structuring finance I Like the venture, finance has a life cycle: 1.Seed/start-up finance 2.1 st round funding 3.2 nd round (mezzanine) funding 4.Late-stage funding The ‘informal’ sector tends to focus on 1. & 2. while the ‘formal’ funds will be involved from 2. to 4., often through the life cycle

Structuring finance II Investors buy equity & appoint board members to exercise control & influence Teams (of angels) or syndicates (via VCs) spread the risks & share the gains Investments staggered in rounds permit growth milestones & hedge the risks Planned exit strategies (e.g. trade sale, IPO) allow investors to harvest the gain

Conclusion Finance is central to new venture formation: Cash is cornerstone to strategic planning Investment is needed to start up & grow Investors provide ideas & experience too Sources depend upon scale and stage Debt/equity balance affects costs & control Understanding risk & return is essential

Sources used Birley & Muzyka, Mastering Entrepreneurship ch. 3 Wickham, Strategic Entrepreneurship ch.19 Freear, Sohl & Wetzel, ‘Angels: personal investors in the venture capital market’ Websites of British Venture Capital Assoc., European Venture Capital Assoc., & National Business Angels Network