MGT 427 CH 12 Informal Risk Capital, Venture Capital, and Going Public
Match the primary stages of the venture capital process (in the left column) with their descriptions (in the right column). Instructions
*First stage- Involves evaluation of the company's business plan *Second stage- Involves discussions between the entrepreneur and the venture capitalist to agree on general terms *Third stage- Involves a detailed review of the company's history, its business plan, its financial history, and target market customers *Fourth stage- Involves the preparation of a comprehensive, internal investment memorandum
Match the primary stages of the venture capital process (in the left column) with their features (in the right column). Instructions
*First stage- The venture capitalist analyzes the economy of the industry and evaluates whether the company is in the industry specified for investment. *Second stage- The venture capitalist seeks a basic understanding of the principal terms of the deal. *Third stage- It is the longest stage of the process, involving between one to three months. *Fourth stage- A document detailing the venture capitalist's findings and the terms and conditions of the investment transaction is prepared.
Match the forms that a company is required to file after going public (in the left column) with their uses (in the right column). Instructions
*Form 10-K-m Used to file annual reports *Form 10-Q- Used to file quarterly reports *Form 8-K- Used to file specific transaction or event reports
Match the types of crowdfunding (in the left column) with their features (in the right column). Instructions
*Lending crowdfunding- It lets borrowers (usually companies) occur debt funds without going to the traditional providers of debt-commercial banks. *Equity crowdfunding- It lets individuals invest in a private firm for a percentage share of the firm. *Real estate crowdfunding- It is involved in buying properties, providing mortgages, or funding solar energy projects.
Match the terms related to acquisition financing (in the left column) with their definitions (in the right column). Instructions
*Leveraged buyouts- Management buying out the present owners *Going private- A publicly held firm buying out existing stockholders
Match the stages of expansion or development financing of a venture (in the left column) with their descriptions (in the right column). Instructions
*Second stage- Working capital for initial growth phase, but no clear profitability or cash inflow yet *Third stage- Extensive expansion for company with rapid sales growth *Fourth stage- Bridge financing to equip company for public offering
Match the types of early-stage financing for startups (in the left column) with their features (in the right column).
*Seed capital- It is generally a relatively small amount of capital required for proof of concept and market feasibility studies. *Startup capital- It is used for developing and selling some initial products of a venture to determine if commercial sales are feasible.
Which of the following startups fulfill the general criteria that most venture capitalists expect a company to satisfy before committing funding to the venture?
-A company that has a unique product in a large and growing market -A company that is predicted to grow exponentially in the next few months
Which of the following are primary advantages of going public for a venture? (Check all that apply.)
-Ability to obtain equity capital -Enhanced ability to borrow
Deal Structure
-Another concern is the deal structure - the terms of the transaction between the entrepreneur and the funding source. -The needs of the funding source include: •Required rate of return. •Timing and form of return. •Amount of control desired. •Perception of the risks involved. -The entrepreneur's needs include: •Degree and mechanisms of control. •Amount of financing needed. •Objectives of the firm.
Why do ventures avoid an initial public offering (IPO)?
-Because of the potential loss of control that can occur in a publicly traded company -Because of the need for increased reporting for a publicly traded company
Ratio analysis
-Calculations of financial ratios can be used as analytical and control mechanisms to test the financial well-being of the firm. -These ratios measure the financial strengths and weaknesses of the venture, but they are only one control measure. -There are industry rules of thumb to use when interpreting the financial data. The different types of ratios are: •Liquidity ratios. •Activity ratios. •Leverage ratios. •Profitability ratios.
Crowdfunding
-Crowdfunding is also an individual investment and can be used to pre-test a product or service. -This brings together various individuals who commit money to projects and companies they support. •Reward-based crowdfunding is when individuals pledge money to a company developing a new technology, a new cultural art project, or a new musical album. •Lending crowdfunding allows borrowing companies to occur debt funds without going to traditional providers. •Equity crowdfunding allows individuals to invest in private companies for a percentage share of the company. •Other crowdfunding sites focus on real estate and human capital.
Where do angel investors find their deals
-Deals are found through business associates, friends, personal searches, investment bankers, and business brokers. -Angel networks are a group of angels organized into networks or funds - a growing, and common, way to find a deal. -Organized angel investor groups are spreading in the U.S. -The network or fund meets about 6-10 times a year where select entrepreneurs may present their business idea. -Investment is made individually or with other interested angels.
Which of the following are the disadvantages of going public for an entrepreneur?
-Increased responsibilities to public stockholders -Increased expenses -Significant loss of control over decision making in the entrepreneur's company
General valuation approaches
-One widely used approach assesses the price of comparable publicly held company's securities - if one can be found. -The present value of future cash flow adjusts for the time value of money and the business and economic risks. -The replacement value is used only for insurance purposes. -The book value adjusts for depreciation and inventory. -The earnings approach provides the best estimate of probable return on investment. -The factor approach uses three weighted factors to determine value: earnings, dividend-paying capacity, and book value. -The approach giving the lowest value is liquidation value.
Identify the true statements about small-business investment companies (SBIC firms). (Check all that apply.)
-SBIC firms were the beginning of the formal venture capital industry. -The Small Business Investment Act of 1958 led to the formation of SBIC firms.
Which of the following are true about lending crowdfunding sites?
-Small loans are provided to local entrepreneurs to fund items such as short-term inventory. -Individuals who want to lend money to entrepreneurs can create their own loan portfolios.
Which of the following criteria does a venture capitalist expect a company to satisfy before committing funding to the company?
-The business opportunity must have significant capital appreciation. -The company should have a strong management team composed of individuals with solid experience and backgrounds. -The product offered by the company must be unique.
Liquidity ratios
-The current ratio measures the short-term solvency of the venture or its ability to meet its short-term debts. •A ratio of 2:1 is favorable but compare with industry standards. =Current assets/current liabilities -The acid test ratio is a more rigorous test of the short-term liquidity of the venture - it eliminates inventory. •A ratio of 1:1 is favorable in most industries. =(Current assets-inventory)/current liabilities
Which of the following are factors that an entrepreneur should consider when valuing a venture?
-The dividend-paying capacity of the venture -The financial data of the venture compared with those of other companies in the industry
Which of the following guidelines should be followed by an entrepreneur when approaching a venture capitalist? (Check all that apply.)
-The entrepreneur should disclose any significant problems or negative situations in the initial meetings with the venture capitalist. -The entrepreneur should avoid selling the project on the basis that other venture capitalists have committed themselves.
Which of the following should an entrepreneur do to be successful in crowdfunding?
-The entrepreneur should structure some rewards that are appropriate for what he or she is trying to get funded. -The entrepreneur should include an emotional appeal in the crowdfunding video.
Identify the factors that need to be considered when deciding the timing of a company going public. (Check all that apply.)
-The finances that the company requires for fulfilling its needs -The amount of the company's earnings -The size of the company
Which of the following statements are true about an equity pool?
-The pool is managed in exchange for a percentage of the gain generated on the investment and a fee. -The pool is managed by a general partner.
Evaluation of an internet company
-The valuation process for early-stage Internet companies is different than from the traditional valuation process. •The qualitative portion of due diligence carries more weight than in other evaluations. -After analyzing the market size and potential revenues of a company, the investor examines the management team. -Though a technology firm may sell for tens of millions, it is uncommon. -The Internet and tech firms are changing how companies are funded. •Valuing a company based on talent may be a growing trend or one that remains within the tech industry.
Identify the practices that help entrepreneurs achieve success in crowdfunding.
-They should determine which crowdfunding site is ideal to raise the capital needed. -They should create a strong crowdfunding video that clearly explains the idea of their venture.
In the context of startups, identify the true statements about informal investors, or angels, in the United States.
-They usually invest in firms that are within one day's travel. -The investment made by informal investors in a firm ranges from $100,000 to $500,000.
VGNS Global, a start-up venture, requires $1,000,000 of venture-capital money. The venture is anticipating profits of $2,000,000 by the fifth year. A venture capitalist wants an investment multiple of 6 times. The price-earnings multiple of a similar company is 12. How much of the percent ownership would the company have to give up to obtain the needed funds from the venture capitalist?
25%
Quiet period
90-day period in going public when no new company information should be released
The venture-capital process
A preliminary screening begins with receipt of the business plan. •Must have a clear mission and objectives. •The executive summary is used for initial screening. •The investor evaluates the business, determines the deal's fit into their portfolio, and investigates the industry and the management team. The second stage is agreement on general terms. The third stage is a detailed review and due diligence. •This is the longest stage, lasting from one to three months. The last stage - final approval - includes a comprehensive investment memorandum.
_____ is a meticulous test of the short-term liquidity of a venture since it eliminates inventory, which is the least liquid current asset.
Acid test ratio
_____ indicates the average number of days required to convert accounts receivable into cash.
Average collection period
Which of the following are the major factors that are used to determine the value of a company using the factor approach?
Book value Earnings Dividend-paying capacity
Venture Capital
Broadly, venture capital is a professionally managed pool of equity capital. The equity pool is fueled by wealthy limited partners. •Other investors are pension funds, endowments, and other institutions including foreign investors. •The pool is managed by a general partner - the venture capital firm - in exchange for a percentage of the gain realized and a fee. Venture capital is a long-term investment. The venture capitalist takes an equity participation and is actively involved - monitoring the company and bringing needed business skills to the firm.
Identify a true statement about the informal risk-capital market.
Business angels in the informal risk-capital market grant the funds needed in all stages of financing, especially in the start-up.
_____ is frequently used to assess the short-term solvency of a venture or its ability to meet its short-term debts.
Current ratio
_____ is the longest stage in the venture-capital process, involving a duration of one to three months.
Due diligence
Which of the following is most likely a feature of state-sponsored venture capital funds?
Each fund is usually required to invest a certain share of its capital in a particular state.
Identify the entities that act as sources of funding for early-stage financing of a startup.
Family Angel investors
The information in _____ on the business, management, and company assets is similar to that in Form S-1 of the registration statement.
Form 10-K
_____ assesses the efficiency of a venture in managing and selling its inventory.
Inventory turnover
Which of the following are traditional areas of concentration of venture capitalists in the United States?
New York Los Angeles
Locating and approaching venture capitalists
Only approach firms who may be interested in your opportunity. •Research prospective firms carefully, including regional and national venture-capital associations. Approach a venture capitalist in a professional business manner. •Seek an introduction - venture capitalists tend to focus on referrals. •Select the right venture capitalist and don't shop your deal around. •Bring only one or two members of the management team. •Develop a brief, well thought-out oral presentation. A favorable first meeting may lead to additional meetings and reaching an initial agreement on terms. If rejected, select several other non-related firms.
_____ were usually established as limited partnerships during the late 1960s, with the venture capital company acting as the general partner that received a management fee and a percentage of the profits earned on a deal.
Private venture capital firms
Crowdfunding campaigns
Successful crowdfunding campaigns take time and planning to develop a marketing campaign, execute the campaign, and provide excellent service. •Determine the crowdfunding site you will use to raise the capital. •Create a video explaining what you are doing with an emotional appeal. •Establish a budget showing short-term costs. •Indicate the specific tasks to be funded. •Structure some appropriate rewards. Establish a deadline for the campaign.
Activity ratios
The average collection period ratio indicates the average number of days it takes to convert accounts receivable to cash. •Compare the result to industry standards. •Accounts Receivable/average daily sales The inventory turnover ratio measures the efficiency of the venture in managing and selling its inventory quickly. •A high turnover is a favorable sign. •=COGS/Inventory
Which of the following should be done when calculating the book value of the stock of a company?
The balance sheet should be adjusted to reflect the higher values of the assets.
Identify a true statement about current ratios used by entrepreneurs for valuation.
The current liabilities must be covered from cash or its equivalent.
Leverage ratios
The debt ratio assesses the firm's ability to meet all its obligations, both short- and long-term. •It also measures risk because debt consists of a fixed commitment of interest and principal repayments. •=total liabilities/ total assets The debt to equity ratio assesses the firm's capital structure. •It measures the risk to creditors by considering the funds invested by creditors (debt) and investors (equity). •The higher the percentage of debt, the greater the risk to creditors. =total liabilities/ stockholder's equity
Identify a true statement about the relationship that an entrepreneur should maintain with the financial community after his or her company goes public.
The entrepreneur should release public disclosures through formal press releases.
Identify a guideline that should be followed by an entrepreneur when approaching a venture capitalist.
The entrepreneur should take care in selecting the right venture capitalist to approach based on the venture capitalist's area of specialization.
Valuing your company
The factors in valuation include: •The nature and history of the business. •The outlook of the economy in general and the industry in particular. •The book value (net value) of the company's stock and the company's overall financial condition. •The future earnings capacity is the most important factor. •The dividend-paying capacity is the future capacity to pay, rather than actual dividend payments. •An assessment of goodwill and other intangibles is the sixth factor. •The seventh factor is assessing the previous sale of equity. The final factor is the market price of similar companies' equity.
Identify a true statement about angel investor groups.
The individual members of the angel group make the investment either individually or with others interested.
Identify a true statement about private venture capital firms that emerged during the late 1960s.
The limited partners, who supplied the funding, were usually institutional investors.
Profitability Ratios
The net profit margin ratio represents the ability to translate sales into profits. •Use gross profit instead of net profit to provide another measure of profitability. •=Net profit/Net sales Return on investment measures the ability to manage the venture's total investment in assets. •Substituting stockholders' equity for assets calculates a return on equity. •Net Profit/ Total Assets
The venture-capital objectives and criteria
The objective of a venture-capital firm is to generate long-term capital through debt and equity investments. •The objective of the entrepreneur is survival of the business. Return on investment criteria increases with increased risk in early-stage financing. The venture capitalist does not seek control of a company but usually wants at least one seat on the board of directors. Investment criteria includes a financially committed, first-rate management team supported by family members. •The product must be unique. The opportunity must have significant capital appreciation.
Which of the following is true about an angel fund?
The private investors or their designated representatives in an angel fund make the investment decisions.
Which of the following is the need of the investors providing funds to companies?
The required rate of return
Overview of the venture-capital industry
The role of venture capital became an industry after WW II with the American Research and Development Corporation (ARD). The Small Business Investment Company Act formed the Small Business Investment Companies (SBIC firms). •SBICs were the start of the formal venture-capital industry. During the 1960s, small private venture-capital firms emerged. •Usually formed as partnerships with the venture-capital firm acting as general partner and the limited partners supplied the funding. •Also, venture-capital divisions of major corporations were formed. The geographically oriented venture-capital fund was created for economic development - varies on a state basis.
Financing the business
The sources of funding develops through stages. •Early-stage financing is the most difficult and costly to obtain. •Seed capital is usually a small amount for proof of concept and market feasibility studies. •Startup financing pays for developing and selling initial products to determine feasibility of commercial sales. •Development financing as working capital supports initial growth. •In the third stage, the company has positive cash flow and uses funds for sales expansion. •Fourth stage funds are used before going public or being purchased. Acquisition financing is used for acquisitions, LBOs, or going public.
Risk-capital markets
There are three risk-capital markets that finance growth. •The public-equity market is available for high-potential ventures. •The venture-capital market provides some first-stage funding for larger ventures. •The best source for first-stage funds is the informal risk-capital market. The private equity market provides capital for private ventures. •The market consists of individuals (angel investors), venture capital firms, and private equity funds.
Identify a true statement about financial ratios of ventures.
They should be used with caution since they are only one control measure for interpreting the financial success of a venture.
General Valuation Method
This approach determines how much of the company a venture capitalist will want for a given investment. •This approach considers the time value of money to determine the investor's share. VC ownership %= (VC $ investment* VC multiple)/[Year 5 profits* (price/earnings multiple)]
True or false: Crowdfunding brings together different individuals who contribute money to projects and firms they want to support.
This is True Crowdfunding brings together different individuals who contribute money to projects and firms they want to support. Crowdfunding is rapidly growing market that is transforming how people behave with their money and business raise capital.
True or false: Market conditions need not be considered by an entrepreneur when deciding the timing of his or her company going public.
This is false. Market conditions affect both the initial price that an entrepreneur will receive for the stock and the aftermarket, or the price performance of the stock after its initial sale. Thus, the market conditions need to be considered when deciding if the company is ready to go public.
True or false: The guidelines established by the Securities Exchange Commission regarding the information that can and cannot be released should be understood only by an entrepreneur in a company.
This is false. The guidelines established by the Securities Exchange Commission regarding the information that can and cannot be released should be understood not only by the entrepreneur but by everyone else in the company as well.
True or false: The venture capitalist necessarily seeks control of a company he or she invests in.
This is false. The venture capitalist does not necessarily seek control of a company and actually would prefer to have the firm and the entrepreneur at the most risk.
True or false: A state-sponsored venture capital fund is typically required to invest a certain percentage of its capital in a particular state.
This is true. A state-sponsored venture capital fund typically is required to invest a certain percentage of its capital in the particular state. Generally, the funds that are professionally managed by the private sector, outside the state's bureaucracy and political processes, have performed better.
True or false: A company that has gone public should designate an information officer to respond in a timely manner to information requests.
This is true. Frequently, it is best to designate one person in the company to be the information officer, ensuring that the press, public, and security analysts are dealt with in a friendly, efficient manner. There is nothing worse than a company not responding in a timely manner to information requests.
True or false: The book value of the stock of a company is usually not a good indicator of its fair market value.
This is true. Frequently, the book value of the stock of a company is not a good indicator of its fair market value, as balance sheet items are almost always carried at cost, not market value.
Informal risk-capital market
This market is a group of wealthy investors - "business angels" - who are looking for equity investment opportunities. •Angels provide funds for all stages but particularly startup funds. •This is the largest pool of risk capital in the U.S. and the size and number of investors has increased. •Angel money available for investment each year is about $20 billion. Informal investors tend to be well educated. •They tend to invest in firms geographically close to them. •They make one or two deals a year, averaging $340,000. •They may join with other angels to finance larger deals.
The venture-capital industry
University-sponsored venture capital funds and philanthropic venture funds are usually managed as separate entities. The venture-capital industry has not returned to the highest level invested in 1999-2000 of $104.7 billion over 7,809 deals. In 2017, the three primary industries invested in were the Internet, healthcare, and business products. The largest amount raised was for later-stage financing in 2017 but traditionally, expansion-stage is the largest category. The New York Metro areas received the largest amount of venture capital geographically.
Which of the following is used to determine the share of the company a venture capitalist will want for a given amount of investment? [VC= venture capital, n= number of years]
VCinvestment×VCinvestmentmultipledesiredCompany'sprojectedprofitsinyear5×Price−earningsmultipleofcomparablecompanyVCinvestment×VCinvestmentmultipledesiredCompany'sprojectedprofitsinyear5×Price-earningsmultipleofcomparablecompany
A social analytics Internet startup is being analyzed for acquisition by WIN Systech Inc., a well-established Internet company. Which of the following factors should WIN Systech Inc. consider when evaluating the startup?
WIN Systech Inc. should value the startup based on the number of users they have and the data generated.
Final approval
a document showing the final terms of the deal
State-sponsored venture-capital fund
a fund containing state government money that invests primarily in companies in the state
Comment letter
a letter from the SEC to a company indicating corrections that need to be made in the submitted prospectus
Business angels
a name for individuals in the informal risk-capital market
Private venture-capital firms
a type of venture-capital firm having general and limited partners
In the context of valuation of a venture, return on equity indicates the _____.
ability of the venture in generating a return to the stockholders
Aftermarket support
actions of underwriters to help support the price of stock following the public offering
Pricing amendment
additional information on price and distribution submitted to the SEC to develop the final prospectus
Actions of underwriters to help support the price of stock after the public offering are referred to as _____.
aftermarket support
A similarity between lending crowdfunding and equity crowdfunding is that they _____.
allows individuals to raise funds without going to the traditional providers of debt-commercial banks
Investment opportunities in a startup are rejected by informal investors, or angels, when there is _____.
an inadequate risk/return ratio
In the process of locating venture capitalists, an entrepreneur should _____.
approach only those venture capitalists who may have an interest in their investment opportunity
Angel investors
are individual investors who act alone without any group affiliation and are known to make the largest number of investments in the private equity market.
Informal risk-capital market
area of risk-capital markets consisting mainly of individuals
The securities of certain smaller companies going public must be qualified under the _____ of each state in which the securities of the company will be offered.
blue-sky laws
The informal risk-capital market consists usually of a virtually invisible group of wealthy investors, often called _____, who are searching for equity-type investment opportunities in a wide variety of entrepreneurial ventures.
business angels
Financial ratios
control mechanisms to test the financial strength of the new venture
The objective of a venture-capital firm is to _____.
create long-term capital appreciation through debt and equity investments
The Jump Start Our Business Act (JOBS Act) of 2010 has effectively allowed companies to be more active in their intent to raise money in what is often referred to as _____.
crowdfunding
The form of the transaction when money is obtained by a company is referred to as _____.
deal structure
The _____ provides an entrepreneur a way to assess a firm's ability to meet all its obligations (short and long term).
debt ratio
Earnings approach
determining the worth of a company by looking at its present and future earnings
Prospectus
document for distribution to prospective buyers of a public offering
The most widely used method of valuing a company is the _____, as it provides the potential investor with the best estimate of the probable return on investment.
earnings approach
To stabilize the market and prevent the price from going below the initial public offering price, an underwriter will usually _____.
enter bids to buy the stock in the early stages after the initial offering
The private equity market, which is also known as the _____, can be a source of capital for privately held ventures.
enterprise capital market
The _____ is created from the resources of wealthy individuals or institutions who are limited partners.
equity pool
Acquisition financing
financing to buy another company
Development financing
financing to rapidly expand the business
Form S-1
form for registration for most initial public offerings of stock
Underwriting Syndicate
group of firms involved in selling stock to the public
Preliminary screening
initial evaluation of a deal
Blue-sky laws
laws of each state regulating public sale of stock
Managing underwriter
lead financial firm in selling stock to the public
A disadvantage of going public for a venture is that it can _____.
lead to potential loss of control
The valuation approach that gives the lowest value of a business is the _____.
liquidation value
The average collection period helps an entrepreneur assess the _____.
liquidity of accounts receivable
Risk-capital markets
markets providing debt and equity to nonsecure financing situations
Registration statement
materials submitted to the SEC for approval to sell stock to the public
General valuation approaches
methods for determining the worth of a company
Equity pool
money raised by venture capitalists to invest
The first factor and the starting point that an entrepreneur should consider when valuing a venture is the _____.
nature and history of the business
The _____ indicates a venture's ability to translate sales into profits.
net profit margin
Factors in valuation
nonmonetary aspects that affect the fund valuation of a company
A venture going public occurs when the entrepreneur and other equity owners of the venture _____.
offer and sell some part of the company to the public by registering with the Securities Exchange Commission
Early-stage financing
one of the first financings obtained by a company
Venture-capital market
one of the risk-capital markets consisting of formal firms
Public-equity market
one of the risk-capital markets consisting of publicly owned stocks of companies
Red Herring
preliminary prospectus of a potential public offering
Although all three risk-capital markets can provide funds for stage-one financing, the _____ is available only for high-potential ventures, when high technology is involved.
public-equity market
Lending crowdfunding sites allow borrowers (usually companies) to _____.
raise funds for items such as short-term inventory
A preliminary prospectus that is filled as a part of the registration process by a company is called a(n) , because a statement printed in red ink appears on the front cover.
red herring
Financial Ratios
refer to control mechanisms to test the financial strength of a new venture. (Enter one word in each blank.)
A(n) _____ includes materials submitted to the Securities Exchange Commission for approval to sell stock to the public.
registration statement
Debt to equity ratio provides a measure of _____.
risk to creditors by considering the funds invested by creditors (debt) and investors (equity)
Going public
selling some part of the company by registering with the SEC
SBIC firms
small companies with some government money that invest in other companies
Small companies with some government funds that invest in other companies are known as _____.
small-business investment companies
Equity participation
taking an ownership position
Replacement value
the cost of replacing all assets of a company
Venture-capital process
the decision procedure of a venture-capital firm
Initial public offering (IPO)
the first public registration and sale of a company's stock
Deal structure
the form of the transaction when money is obtained by a company
Significant capital appreciation
the increase in value of the organization during a specified period of time
Book value
the indicated worth of the assets of a company
Full and fair disclosure
the nature of all material submitted to the SEC for approval
Due diligence
the process of deal evaluation
Unlike traditional companies, Internet companies often have _____.
their real value in the form of their human capital
A group of firms involved in selling stock to the public is known as
underwriting syndicate
Factor approach
using the major aspects of a company to determine its worth
Present value of future cash flow
valuing a company based on its future sales and profits
Referral sources
ways individual investors find out about potential debts
Liquidation value
worth of a company if everything was sold today