Growth Funding Patterns of Entrepreneurship Chapter 7 Session 6: Financial Alternatives for Debt and Equity Capital

copyright 2003 Jack M. Kaplan Session Outline Understand the Venture Capital Process Private Placement Process Value the Venture Select the Valuation Method Prepare a Presentation to Investors

copyright 2003 Jack M. Kaplan  Venture capital firms  Investment banking firms  Insurance companies  Large corporations Growth Equity Investors

copyright 2003 Jack M. Kaplan Understand the Venture Capital Process  Specialized Industries for the venture  The Location of the Venture  Stage of Development  Early Stage Financing  Expansion Financing  Acquisioion/Buyout Financing

copyright 2003 Jack M. Kaplan  VC firms want returns of 30% or more  Only for high-growth companies  Require deals over $2 million to invest  Most often, VC is not available until the company is ready for commercialization of the product or services  Most want a exit strategy in 3-5 years Venture Capitalists

copyright 2003 Jack M. Kaplan The Venture Capital Process Entrepreneurs Venture Capitalists Investment Bankers Private Investors Public Market Corporations Angles Funds Ideas Funds IPO’s MoneyStock

copyright 2003 Jack M. Kaplan The Logic of the Deal Typical start-up - Venture Capital Fund will invest 2-3 million for 40% preferred equity ownership position. This gives V.C. a liquidation preference over common shares until the 2-3 million is returned. If Venture fails, they have first claim to assets and technology. Also blocking rights over key decisions including sale of the company and IPO.

copyright 2003 Jack M. Kaplan Antidilution clauses or “Rachets” - This protects against equity dilution of additional rounds of financing at lower values take place. This preferential treatment comes at the expense of all common shareholders. If company does well, V.C. enjoys upside provision by having right to put additional money at a set price. Limit risk by co-investing with other firms.

copyright 2003 Jack M. Kaplan The VC “LANDSCAPE” in 2000 # of VC Firms in Existence # of Professionals # of First Time VC Funds Raised # of VC Funds Raised This Year VC Capital Raised This Year ($B) Avg VC Fund Size Raised This Year ($M) Source: NVCA Yearbook 2001; Venture Economics

copyright 2003 Jack M. Kaplan The Committed Capital Bubble Source: VentureOne Years Accumulated Capital Over-commitments ($B)

copyright 2003 Jack M. Kaplan The Illiquid Bulge From : 14, ,529 1,180 10,776 Companies funded Went public Were acquired Went out of business Remaining Source: Venture Economics; Venture Source - - -

copyright 2003 Jack M. Kaplan A Generic Late 90’s Model Round TypeDate Amount Raised (MM) Pre-Money Valuation (MM)IRRMultiple 1SeedJan-97 $ 5 $ 3579% stJan-98 $ 10 $ 10065% ndJan-99 $ 25 $ 20059% rdJan-00 $ 60 $ 60052% IPOJan-01 $ 1000 $ 100 Million

copyright 2003 Jack M. Kaplan A Generic Early 90’s Model Round TypeDate Amount Raised (MM) Pre-Money Valuation (MM)IRRMultiple 1SeedJan-90 $ 0.50 $ 2101% stJan-91 $ 3.00 $ 1070% ndJan-92 $ 8.00 $ 3250% rdJan-94 $ $ 10032% IPOJan-95 $ 150 $ 25 Million

copyright 2003 Jack M. Kaplan Why It’s Great To Be An Entrepreneur - TODAY US Venture Capital Partnership Returns Versus Public Market Returns Funds Formed (quarterly returns) Source: Venture Economics/NVCA

copyright 2003 Jack M. Kaplan  The opportunity is considered “hot” area  The venture delivers scalable technology  There are client references  The team is diligent and goal  The entrepreneur is skilled in finance, capital and deal structures  Realistic expectations are incorporated into goals of the company Profile of the Ideal Entrepreneur from a VC Perspective

copyright 2003 Jack M. Kaplan Two Formal Methods: Private placement Public stock offering Private placement controlled by Regulation D of the Federal Securities Act Rule 504 Up to $1,000, month completion period No restrictions on the number of investors Equity Financing

copyright 2003 Jack M. Kaplan Rule 505 Up to $5 million 12 month completion period No more than 35 non accredited investors and unlimited number of accredited investors Rule 506 Unlimited amount of raising funds No more than 35 unaccredited but sophisticated purchasers.and to unlimited number of accredited investors. must be able to evaluate merit and risks. Equity Financing

copyright 2003 Jack M. Kaplan  First: Determine motive for valuing the business –Selling stock or buying a business  Second: Define what is to be valued –Entire company, product line or a unit division –Income stream determination  Third: Set a point in time for valuation Valuation Process

copyright 2003 Jack M. Kaplan  Recent profit history  General conditions of company  Market demand and competition -- at time of offering  Ability to transfer goodwill  Future profit potential  Management team Factors to Assess a Company’s Value

copyright 2003 Jack M. Kaplan  Valuation: Select the valuation method –Apply the methods and compute valuation  Weight the Values: Apply a percentage allocation to each value (E.G.: 40% to adjusted book value, 30% price earnings, and 30% to discounted value) Determine Value and Weight

copyright 2003 Jack M. Kaplan  Asset Valuations  Earnings Valuations  Discounted Cash Flow Valuation Valuation Techniques

copyright 2003 Jack M. Kaplan  No single valuation captures the real value of the firm. Value is the perception of opportunity, risk, and financing resources available.  Difference is determined by vision, market analysis, time pressures, and negotiating. Valuation Statement

copyright 2003 Jack M. Kaplan  Asset Valuation –Book Value –Adjusted Book Value –Liquidation Value –Replacement Value What is the Business Worth?

copyright 2003 Jack M. Kaplan  Book value –Current assets + property + equipment (net of depreciation) –Total net worth  Used primarily for accounting purposes Asset Valuation

copyright 2003 Jack M. Kaplan  Current assets + market value of property + equipment + intangible assets  Adjusts for large discrepancies (land, equipment)  Better reflects actual market value Adjusted Book Value

copyright 2003 Jack M. Kaplan  If the business is sold  Value of assets - quick sale  Asset valuation does not consider intangible factors such as reputation, talent, or goodwill Liquidation Value

copyright 2003 Jack M. Kaplan  Historical Earnings  Future Earnings –Projected earnings –Nature of industries and similar companies –Anticipated economic conditions Earnings Valuation

copyright 2003 Jack M. Kaplan  Prepare Executive Summary –Company, market potential, marketing strategy, competitive position, milestones, product position, financial summary  Prepare Forecast: 1-3 Years –Monthly: year 1 –Quarterly: year 2 and 3  Choose Valuation Process Earning Valuation for Start-Up Companies

copyright 2003 Jack M. Kaplan  Determine P.E. Ratio –Select similar public companies if available –Use S&P quarterly industry analysis handbook for your P.E. ratio –Reduce P.E. by 50%, if your size is smaller and illiquidity factor (holder may not be able to sell shares without considerable effort). Earning Valuation

copyright 2003 Jack M. Kaplan  Use Factors for Rating Scale of 1-6 –Risk assessment –Competitive position –Industry and company –Growth opportunity –Desirability –Total and average How to Calculate P.E. Multiple

copyright 2003 Jack M. Kaplan  Form a corporation  Authorize 2 million shares  Issue 1million shares  Projected P&L is $200,000 Profit after 3 years (EBIT)  Projected P.E. is 12 for your industry (after careful analysis) Guidelines Using Earning Valuation

copyright 2003 Jack M. Kaplan  Value company at 2.4 million today  Each share is $2.40 outstanding  Determine amount you require to raise –Sell 100,000 $2.40 –You are offering 10% of the company for $240,000 Value Guidelines

copyright 2003 Jack M. Kaplan  Select adviser(s)  Complete business plan  Define use of funds  Seek qualified advise from lawyer  Select a mentor to advise you  Target investor group – Personal, family, angels, professional Guidelines

copyright 2003 Jack M. Kaplan  Prepare a Presentation to Investors –Non-Disclosure / Non-Compete Agreement –Demo of product –Hand-outs –PowerPoint presentation –Determine if you want qualified or determine if you want qualified or non- qualified investors –Subscription Agreements Guidelines

copyright 2003 Jack M. Kaplan  Is useful to investors who are attempting to appraise a return on investment and return on time  Forecasts cash flows and discounts them back to the business  Must have positive cash flow - Calculate Discounted Cash Flow Valuation

copyright 2003 Jack M. Kaplan  Terminal value –Return of capital via sale  Tax benefits  Operating cash flows –Business related expenses (car, club membership) –Salary and dividends Discounted Cash Flow Valuation