Ch 8: Sources of Capital for Entrepreneurs

Debt versus equity financing

(1) take on debt without giving up ownership in the venture or (2) relinquish a percentage of ownership in order to avoid having to borrow.

5 major aspects of the plan VCs generally will analyze:

(1) the proposal size (2) financial projections (3) investment recovery (4) competitive advantage (5) company management.

finance companies

- asset-based lenders that lend money against assets such as receivables, inventory, and equipment. - The advantage of dealing with a commercial finance company is that it often will make loans that banks will not.

Factoring

- sale of accounts receivable. - Under this arrangement, the receivables are sold, at a discounted value, to a factoring company.

Accounts receivable financing

- short-term financing that involves either the pledge of receivables as collateral for a loan or the sale of receivables (factoring). - made by commercial banks, whereas factoring is done primarily by commercial finance companies and factoring concerns.

Convertible debentures

- unsecured loans that can be converted into stock. - The conversion price, the interest rate, and the provisions of the loan agreement are all areas for negotiation.

2 largest P2P companies

1. Lending Club 2. Prosper

Financial equity instruments, which give investors a share of the ownership, may include:

1. Loan with warrants 2. Convertible debentures 3. Preferred stock 4. Common stock

Pros of dealing with angel investors

1. engage in smaller financial deals. 2. prefer seed stage or start-up stage. 3. invest in various industry sectors. 4. located in local geographic areas. 5. genuinely interested in the entrepreneur.

Cons of dealing with angel investors

1. offer no additional investment money. 2. cannot offer any national image. 3. lack important contacts for future leverage. 4. may want some decision-making with the entrepreneur. 5. getting more sophisticated in their investment decisions.

Stage 2: Evaluation of the Business Plan

A detailed reading of the plan is done to evaluate the factors mentioned earlier.

Crowdfunding

A recent financial phenomenon of the 21st century is the creation of a funding vehicle for ventures through the use of the general public. - this practice seeks funding for a venture by raising monetary contributions from a large number of people, typically via the internet.

Stage 4: Final Evaluation

After analyzing the plan and visiting with suppliers, customers, consultants, and others.

private placement

Another method of raising capital Small ventures often use this approach.

business angels or informal risk capitalists.

Many wealthy people in the United States are looking for investment opportunities;

insurance companies

most commonly used for long-term financing

How do informal investors find projects to invest in?

networks of friends

Equity capital

not a loan but a form of stock.

Venture capitalists

professional investors who invest in business ventures, providing capital for start-up, early stage, or expansion. - looking for a higher rate of return than would be given by more traditional investments.

Corporate angels

senior managers at Fortune 1000 corporations who have been laid off with generous severances or have taken early retirement.

debt-based crowdfunding

takes place online on peer-to-peer lending companies' websites using various different lending platforms. This form of financing is a 21st century phenomenon.

Micromanagement angels

very serious investors. Some of them were born wealthy, but the vast majority attained wealth through their own efforts. Unfortunately, this heritage makes them dangerous. Because most have successfully built a company, micromanagers attempt to impose the tactics that worked for them on their portfolio companies. Although they do not seek an active management role, micromanagers usually demand a seat on the board of directors.

Attributes evaluating new-venture proposals

Timing of entry Key success factor stability Educational capability Lead time Competitive rivalry Entry wedge mimicry Scope Industry-related competence

angel capital

Software remained the top sector position with 23 % of total angel investments media (16 %) healthcare services/medical devices and equipment (14 %) biotech (11 %)

Evaluation process:

Stage 1: Initial Screening Stage 2: Evaluation of the Business Plan Stage 3: Oral Presentation Stage 4: Final Evaluation

Stage 3: Oral Presentation

The entrepreneur verbally presents the plan to the VC.

Direct public offerings (DPOs)

It eases the regulations for the reports and statements required for selling stock to private parties—friends, employees, customers, relatives, and local professionals.

Social lending sites

Kiva.org, a non- profit organization that allows donors to make zero-interest loans to specific causes around the globe

Rule 505—placements of up to $5 million

The criteria for a public offering exemption are somewhat more difficult to meet than those for smaller offerings. Sales of securities can be made to not more than 35 nonaccredited purchasers and to an unlimited number of accredited purchasers. If purchasers are nonaccredited as well as accredited, then the company must follow specified information disclosure requirements. Investors must have the opportunity to obtain additional information about the company and its management.

Venture Capitalists' Due Diligence "Deal Killers"

1. An arrogant management team. 2. No defendable market position. 3. Excessive founder salaries. 4. Vulnerability of the founder. 5. Yesterday's news. 6. Ignorance of the competitive landscape. 7. Unrealistic expectations.

5 types of angel investors

1. Corporate angels 2. Entrepreneurial angels 3. Enthusiast angels 4. Micromanagement angels 5. Professional angels

accredited purchaser

Included in this category are institutional investors such as: - banks - insurance companies - venture capital firms - registered investment companies - small-business investment companies (SBICs) - wealthy individuals, - certain tax-exempt organizations with more than $5 million in assets. Everyone not covered in these descriptions is regarded as a nonaccredited purchaser.

SEC

Securities and Exchange Commission

"angel stats"

Typical deal size: $250,000-$600,000 Typical recipient: Start-up firms Cash-out time frame: 5 to 7 years Expected return: 35% - 50% a year Ownership stake: Less than 50%

Success with acquiring funding is related to 4 general, variable categories:

(1) characteristics of the entrepreneurs, including education, experience, and age. (2) characteristics of the enterprise, including stage, industry type, and location (e.g., rural or urban) (3) characteristics of the request, including amount, business plan, and prospective capital source. (4) sources of advice, including technology, preparation of the business plan, and places to seek funding.

Disadvantages of going public

- Costs - Disclosure - Requirements - Shareholder pressure

Rule 506—placements in excess of $5 million

- Sales can be made to no more than 35 nonaccredited purchasers and an unlimited number of accredited purchasers. - the nonaccredited purchasers must be "sophisticated" in investment matters. - the specific disclosure requirements are more detailed than those for offerings between $500,000 and $5 million. Investors must have the opportunity to obtain additional information about the company and its management.

Advantages of going public

- Size of capital amount - Liquidity - Value - Image

debt financing

- a new venture involves a payback of the funds plus a fee (interest) for the use of the money. - a burden on the entrepreneur of loan repayment with interest. - not a choice but a necessity - most common sources = commercial banks.

Preferred stock

- equity that gives investors a preferred place among the creditors in the event the venture is dissolved. - The stock also pays a dividend and can increase in price, thus giving investors an even greater return. - Some preferred stock issues are convertible to common stock, a feature that can make them even more attractive.

Common stock

- most basic form of ownership. - usually carries the right to vote for the board of directors. - If a new venture does well, common-stock investors often make a large return on their investment. - sold through public or private offerings.

Rule 504—placements up to $1 million.

No specific disclosure/information requirements and no limits on the kind or type of purchasers exist. This makes marketing offerings of this size easier than it was heretofore.

Professional angels

professional in this context refers to the investor's occupation, such as doctor, lawyer, and, in some very rare instances, accountant. Professional angels like to invest in companies that offer a product or service with which they have some experience. They rarely seek a board seat, but they can be unpleasant to deal with when the going gets rough and may believe that a company is in trouble before it actually is.

"Sophisticated" investors

wealthy individuals who invest more or less regularly in new and early- and late-stage ventures. They are knowledgeable about the technical and commercial opportunities and risks of the businesses in which they invest. They know the kind of information they want about their prospective investment, and they have the experience and ability needed to obtain and analyze the data provided.

potential lending dangers:

• Funding success rate. • Business plan disclosure. • No ongoing counseling relationship. • Potential tax liability. • Uncertain regulatory environment.

Trade credit

- given by suppliers who sell goods on account. - reflected on the entrepreneur's balance sheet as accounts payable, and in most cases, it must be paid in 30 to 90 days. - Many small, new businesses obtain this credit when no other form of financing is available to them.

Equity financing

- involves the sale of some of the ownership in the venture. - forces the entrepreneur to relinquish some degree of control - money invested in the venture with no legal obligation for entrepreneurs to repay the principal amount or pay interest on it. - requires no repayment in the form of debt.

Peer-to-peer lending

- lending money to unrelated individuals, or "peers," without going through a bank or other traditional financial institution. - Internet-based sites that pool money from investors willing to lend capital at agreed-upon rates. - charge fees for brokering and servicing loans and collect penalties for late payments as well. AKA: P2P or "debt-based crowdfunding"

other debt-financing sources

1. trade credit 2. accounts receivable factoring 3. finance companies 4. leasing companies 5. mutual savings banks 6. savings and loan associations 7. insurance companies

A number of reasons VCs have increased investments in early stage funding:

• The ease and efficiency to launch a venture, get the product to market, and reach larger markets than ever before. • Sharp reductions in infrastructure costs because of cloud-based computing. • Shorter product cycles and iterative development processes. • Selling to global consumers has become feasible for start-up entrepreneurs who can ac- cess much larger markets through the Internet. • College graduates have more sophisticated knowledge about some of the most important technological developments such as mobile, social, and cloud.

Loan with warrants

- provides the investor with the right to buy stock at a fixed price at some future date. - Terms on the warrants are negotiable. - The warrant customarily provides for the purchase of additional stock, such as up to 10 % of the total issue at 130% of the original offering price within a 5-year period following the offering date.

initial public offering (IPO)

- represent the registered public offering of a company's securities for the first time. - Many times, the number of companies "going public" does not vary much, but the amount of financing raised certainly does.

Key Questions or Evaluating a VC Firm

1. Does the venture capital firm in fact invest in your industry? How many deals has the firm actually done in your field? 2. What is it like to work with this venture capital firm? Get references. (An unscreened list of referrals, including CEOs of companies that the firm has been successful with—as well as those it has not—can be very helpful.) 3. What experience does the partner doing your deal have, and what is his or her clout within the firm? Check out the experiences of other entrepreneurs. 4. How much time will the partner spend with your company if you run into trouble? A seed-stage company should ask, "You guys are a big fund, and you say you can seed me a quarter of a million dollars. How often will you be able to see me?" The answer should be at least once a week. 5. How healthy is the venture capital fund, and how much has been invested? A venture firm with a lot of troubled investments will not have much time to spare. If most of the fund is invested, there may not be much money available for your follow-on rounds. 6. Are the investment goals of the venture capitalists consistent with your own? 7. Have the venture firm and the partner championing your deal been through any eco- nomic downturns? A good venture capitalist won't panic when things get bad

6 major categories evaluating new-venture proposals:

1. Entrepreneur's personality 2. Entrepreneur's experience 3. Product or service characteristics 4. Market characteristics 5. Financial considerations 6. Nature of the venture team

proven bootstrapping techniques to keep in mind:

1. Make the most of what you have. 2. Be frugal. 3. Search rummage (or garage) sales 4. Leverage the resources of others. 5. Wear multiple hats in the venture. 6. Share office space. 7. Hire student interns to assist in your business. 8. Find used furniture and equipment to purchase. 9. Encourage customers to pay early. 10. Trade equity for services (not too much though)

advantages of debt financing

1. No relinquishment of ownership is required. 2. More borrowing, potentially, allows for greater return on equity. 3. Low-interest rates reduce the opportunity cost of borrowing.

Disadvantages of Debt Financing

1. Regular (monthly) interest payments are required. 2. Cash-flow problems can intensify because of payback responsibilities. 3. Heavy use of debt can inhibit growth and development

Potential concerns with crowdfunding:

1. Reputation. reaching financial goals and successfully gathering substantial public support but being unable to deliver on the venture could have a negative impact. 2. IP protection. concerns about idea theft and protecting intellectual property. 3. Donor dilution. if the same network of supporters is reached out to multiple times, they will eventually tire of the necessary support. 4. Public fear. without a proper regulatory framework, the likelihood of a scam or an abuse of funds is high

4 separate exemptions regulation D defines, which are based on the amount of money being raised

1. Rule 504—placements up to $1 million. 2. Rule 505—placements of up to $5 million. 3. Rule 506—placements in excess of $5 million.

criteria for evaluating new-venture proposals

1. Timing of entry 2. Key success factor stability 3. Educational capability 4. Lead time 5. Competitive rivalry 6. Entry wedge imitation 7. Scope 8. Industry-related competence

Venture Capitalists' ScreenIng Criteria

1. Venture Capital Firm Requirements - Must fit within lending guidelines of venture firm for stage and size of investment - Proposed business must be within geographic area of interest - Prefer proposals recommended by someone known to venture capitalist - Proposed industry must be kind of industry invested in by venture firm 2. Nature of the Proposed Business - Projected growth should be relatively large within 5years of investment 3. Economic Environment of Proposed Industry - Industry must be capable of long-term growth and profitability - Economic environment should be favorable to a new entrant 4. Proposed Business Strategy - Selection of distribution channel(s) must be feasible - Product must demonstrate defendable competitive position 5. Financial Information on the Proposed Business - Financial projections should be realistic 6. Proposal Characteristics - Must have full information - Should be a reasonable length, be easy to scan, have an executive summary, and be professionally presented - Must contain a balanced presentation - Use graphics and large print to emphasize key points 7. Entrepreneur/Team Characteristics - Must have relevant experience - Should have a balanced management team in place - Management must be willing to work with venture partners - Entrepreneur who has successfully started previous business given special consideration

5 most common questions to secure a bank loan

1. What do you plan to do with the money? 2. How much do you need? 3. When do you need it? 4. How long will you need it? 5. How will you repay the loan?

major trends in venture capital over the last few years

1. predominant investor class is changing from individuals, foundations, and families to pension institutions 2. innovation has become more global and is no longer the exclusive domain of Silicon Valley and Route 128 in Boston. 3. funds are becoming more specialized and less homogeneous. The industry has become more diverse, more specialized, and less uniform than is generally though. 4. syndicated deals are emerging. Accompanying this specialization is a new "farm team" system. Large, established venture capital firms have crafted both formal and informal relationships with new funds as feeder funds. 5. small start-up investments have weakened over the last decade. Many venture capital firms have experienced challenges with some of the high-risk ventures in today's technological environment 6. industry has become more efficient and more responsive to the needs of the entrepreneur as a result of greater professionalism and greater competition. 7. trend is toward a stronger legal environment. The heated competition for venture capital in recent years has resulted in a more sophisticated legal and contractual environment. The frequency and extent of litigation are rising.

2 distinct forms of crowdfunding

1. rewards crowd: funding, the entrepreneur will seek a target amount of funding to launch a business concept without incurring debt or sacrificing equity. In return for a donation from those interested in the venture, the entrepreneur provides some type of gift or incentive for participating (e.g., t-shirt, gift card). 2. equity crowdfunding: where the entrepreneur will share equity in the venture, usually in its early stages, in exchange for the money pledged.

venture capital Myths

1. venture Capital Firms Want to own control of your ComPany and tell you hoW to run the business 2. venture Capitalists are satisfied With a reasonable return on investments 3. venture Capitalists are quick to invest 4. venture Capitalists are interested in backing new ideas or high-technology inventions— management is a secondary consideration 5. venture Capitalists need only basic summary information before they make an investment

Who Is Funding EntrepreneurIal start-up Companies?

IPOs: $5M+ Private Placements: $500K+ Banks & Gov't Programs: $5K+ Venture Capital: $2-$50M Seed Capital: $500K - $3M Angels: $100K - $2M Family & Friends: $20K - $250K Owner's Money: $10K- $100K

Venture CapItalist system of evaluatIng riskiest status of Product/Service

Level 4: Fully developed product/service Established market Satisfied users Level 3: Fully developed product/service Few users as of yet Market assumed Level 2: Operable pilot or prototype Not yet developed for production Market assumed Level 1: Product/service idea Not yet operable Market assumed

Venture CapItalist system of evaluatIng riskiest status of Management:

Level 4: Fully staffed, experienced management team Level 3: Partial management team Members identified to join company when funding is received. Level 2: 2 founders Other personnel not yet identified Level 1: Individual founder/ entrepreneur

Regulation D

allows smaller firms to sell stock through what is referred to as direct public offerings (DPOs)

Entrepreneurial angels

most prevalent type of investors, most of these individuals own and operate highly successful businesses. Because these investors have other sources of income, and perhaps significant wealth from IPOs or partial buyouts, they will take bigger risks and invest more capital. The best way to market your deal to these angels, therefore, is as a synergistic opportunity. Reflecting this orientation, entrepreneurial angels seldom look at companies outside of their own area of expertise

Stage 1: Initial Screening

quick review of the basic venture to see if it meets the VC's particular interests.

Going public

refer to a corporation's raising capital through the sale of securities on the public markets.

Enthusiast angels

simply like to be involved in deals. Most enthusiast angels are age 65 or older, independently wealthy from success in a business they started, and have abbreviated work schedules. For them, investing is a hobby. As a result, they typically play no role in management and rarely seek to be placed on a board.

financial services for new or growing ventures, from venture capitalists:

• Capital for start-ups and expansion • Market research and strategy for businesses that do not have their own marketing departments • Management-consulting functions and management audit and evaluation • Contacts with prospective customers, suppliers, and other important businesspeople • Assistance in negotiating technical agreements • Help in establishing management and accounting controls • Help in employee recruitment and development of employee agreements • Help in risk management and the establishment of an effective insurance program • Counseling and guidance in complying with a myriad of government regulations

Assumptions could be made to demonstrate the power of individuals' ability to finance new ventures

• The aggregate net worth of the Forbes richest 400 Americans was $2.29 trillion ($5.73 billion per person) • 11 members of the list are under 40 years old • 10 of the top 15 are entrepreneurs including: 1. Bill Gates (Microsoft); 2. Warren Buffett (Berkshire Hathaway); 3. Larry Ellison (Oracle); 4. Charles and David Koch (Koch Industries); 5. Michael Bloomberg (Bloomberg); 6. Mark Zuckerberg (Facebook); 7. Larry Page & Sergey Brin (Google); 8. Jeff Bezos (Amazon). Their total worth is $444 billion • If 1% of those entrepreneurs' wealth were available for venture financing, the pool of funds would amount to $4.4 billion. • 113 billionaires did not even make the list. If 1% of their funds were available for venture financing, the pool of funds would be at least $1.1 billion • If both amounts could be available for venture deals, there would be a total of $5.5 billion. • If the typical venture deal took $200,000 there would be the potential of 27,500 deals!