Entrepreneurship 3

Market value of comparable companies

- looks at the price (and number of outstanding shares) of comparable companies' stock Need to adjust based on size, dividends, leverage, and growth potential of the venture versus those of comparable firms, but can give a starting point Difficult to use if truly similar companies don't exist

Small business investment companies (SBICs

- small companies that receive government funds to invest in startups and growing small businesses Approximately 360 in operation currently, include a significant number of minority small business investment companies that specialize in ventures run by members of minority groups

Size and scope of venture capital market

2016: $60 billion invested in 1773 deals Demonstrates that average deal size is MUCH larger than deals made with angel investors 2017: 41% of capital was invested in internet ventures 17% in health care, 13% in business products and services 2017: 42% of capital was invested in late-stage funding 32% in expansion stage, only 12% in early stage 2017: VC capital invested largely in a few geographic areas 22% in NYC metro area, 34% in Bay Area/Silicon Valley

Third major form of joint venture - international joint venture. Benefits?

Access to new markets, knowledge about those markets, shared talent and financing, increased potential for growth and earnings But, can sometimes be complicated by conflicting goals of the two firms, cultural differences, different government policies, etc. Ex. Joint venture between Dow Chemical and Asaki Chemicals to develop and market chemicals in international markets

Angel groups and funds

Angel group - network of individual investors, meets a few times per year and screens presentations from ventures Make investments either individually or with others from the group Pool funds to support presentation and screening processes Entrepreneurs submit an application to a member of the angel group, and promising proposals are invited to make presentations at upcoming meetings 10-30 minute presentation and question period Interested members follow up about investment process

Equity crowdfunding

Angelist, CircleUp, Funding Circle, etc. Allow individuals to make small equity investments in new and growing ventures

Zone of Possible Agreement:

Area between seller's bottom price and buyer's top price

Development (expansion) financing - funds needed to expand the business

Can be easier to obtain now that a product and market feasibility has been established Venture capitalists may be an option at this point - need for $1 million or more is more likely Generally three stages of development financing - initial growth, major expansions, and bridge funding before the venture is acquired or goes public Can provide working capital for growth, expansion into new markets, new facilities, etc.

Private offerings - a formalized method for getting funds from private investors

Faster and less expensive than going through SEC requirements for a public offering Governed by Regulation D - specifies what situations qualify for a private offering

Government grants Eligibility requirements:

Fewer than 500 employees, at least 51% of venture owned and controlled by U.S. citizens or permanent residents Must meet topics/requirements of the grant opportunity offered by the specific agency (e.g., Dept. of Defense, Dept. of Energy, Dept. of Health and Human Services, etc.) Proposals are evaluated by scientists or engineers in the content area, and grants are awarded to ventures with greatest promise for future commercialization Venture retains all patent rights, research and technical data, software, etc. generated through the grant-funded research

Real estate crowdfunding

Fundrise, Crowdstreet, etc. Allow individual investors to fund ventures involved in buying property, providing mortgage, funding solar energy projects, etc.

Reward-based crowdfunding

Indiegogo, Kick Starter, etc. Individuals pledge money to a venture that develops a particular product Tech products, art projects, music albums, etc.

Mergers

Joining two or more companies into one, with only one continuing to exist after the merger Many possible reasons for engaging in a merger Defensive reasons (losing market to superior competitor products, having obsolete technology compared to competitors, etc.) Offensive reasons (attempts to grow by gaining in market position, financial strength, managerial talent, etc.)

Return on investment

Net profit/total assets Ex. $16,300/$152,300 = 10.7% Represents profitability as a proportion of asset investment - what is a favorable percentage depends on the specific industry

external sources of funds

Personal funds - savings, lie insurance, mortgage on a house or car, etc. Often the least expensive (don't require debt or equity), and easiest to control Almost all ventures involve some amount of personal funds - why? Shows commitment to the venture - outside investors and lenders want to see the entrepreneur will have "skin in the game" and have clear motivation to persist through problems Often more about the proportion of the entrepreneur's available assets invested, than about the dollar amount I.e., showing the entrepreneur has invested whatever they can to make the venture a reality family and friends - usually smaller amounts of capital invested in exchange for a small amount of equity Relationship with entrepreneur can overcome uncertainty experienced by other investors Can be easier to ask them for money, what problems might this create? Could be awkward, or potentially they could attempt to influence the venture and cause problems But, usually tend to be more patient than outside investors in terms of demanding fast returns To minimize problems, entrepreneur should treat them like any other investor - use a formal written agreement specifying terms and schedule of loan repayment or timing of dividends on an equity investment Multiple different types of bank loans, based on the asset base for the loan (i.e., the assets that will serve as the collateral for the loan Accounts receivable loan!!!!! - the venture's accounts receivable (the sales that have not yet been collected) serve as the collateral for the loan Especially likely if the venture is well-known The bank "buys" the accounts receivable for less than the face value of the sale and collects the money directly from the customer If accounts aren't collected, the bank takes the loss Ex. Buy the account for 80% of its value, in exchange for the risk of a loss commercial banks - a frequent source of short-term funds in the form of debt equity (requiring collateral) Inventory loan!!!! - the venture's finished goods inventory serves as the collateral for the loan Might receive a loan of up to 50% of the value of the finished goods inventory Equipment loan!!!! - the venture's equipment serves as the collateral for the loan, typically longer term financing May use an equipment loan to purchase new equipment or to raise capital based on equipment already owned (approx. 50-80% of its value) Sale-leaseback financing - entrepreneur sells the equipment to the lender and leases it back Lease financing - entrepreneur makes a small down payment and agrees to make recurring payments over time Real estate loans!!!! - what's this commonly known as? Mortgage Can generally obtain financing of up to 75% of the value of a purchase of land, plant, or building bank lending decisions- how to banks decide to lend (or not) to a prospective entrepreneur? .combinations of objective and subjective factors .five c's of lending: character, capacity, capital, collateral, conditions. .character and capacity can be harder to assess objectively, involves intuition (gut feeling) of the loan officer some of these can be more objectively assessed (i.e., capital, collateral, conditions) Balance sheets and income statements can show profitability, credit ratios, inventory turnover, accounts receivable, entrepreneur's capital investments Future projections regarding market size, sales, profitability, etc. can help show ability to repay the loan

Liquidation value

calculates the value of the venture if it were to sell all of its assets and inventory, terminate employees, and collect all accounts receivable today Gives the lowest value of the approaches, but good for an investor to know (serves as a worst-case scenario)

Angel fund

collective of individual investors that put money into a fund that is generally managed by one individual Managed similarly to a small venture capital fund, but investors have more say in investment decisions Either make decisions directly, or have significant influence over the angel fund manager's decisions Relatively rare because individual investors often prefer to make their investments on an individual, deal-by-deal basis

Two different ways of thinking about different sources of capital:

debt versus equity financing, and internal versus external funds

Deal structure Beyond the value of the venture, what other considerations do the entrepreneur and a VC firm need to agree upon in order to make a deal? Considerations for the VC firm:

desired rate of return, timing and form of the return, amount of control desired, perception of risks

Rapidly-growing form of risk capital

expected to grow at 100% per year, reaching $300 billion in next few years

Early-stage financing

funds acquired to launch the venture Can be the most difficult, as there's often no track record or even proof of concept available

Private venture capital firms

limited partnership of investors (limited partners) and a general partner (the VC firm) General partner manages the fund in exchange for a management fee and a share of the gains Limited partners provide capital - often institutional investors (insurance companies, endowment funds, pension funds, etc.)

Present value of future cash flow

looks at the venture's cash flow and adjusts for risk and time value of money Adjusts for risk (i.e., valuation reflects a discount for the potential that the venture will not achieve projected sales and earnings) Valuation price reflects that risk as well as investors' desired rate of return

Replacement value

not commonly used - primarily for insurance purposes or other unique cases (i.e., the venture possesses a particular unique asset the buyer really wants) Valuation is based on how much it would cost to replace that key asset

Government grants

opportunities for technology-based ventures to receive funding from the federal government All federal agencies with research and development budgets >$100 million are required to provide grant opportunities for small businesses Ventures submit grant proposal directly to the agency, which evaluates proposals on a competitive basis and awards funds to selected ventures Three phases:

Considerations for the entrepreneur:

pretty similar Amount of financing needed, degree of control given up and ways the VC firm will get to exert control, objectives of the venture (short-term and long-term) Need to think through these things and determine non- negotiables before entering into discussion of deal Important for both parties to agree on an effective working relationship to resolve potential future issues that may arise

Activity ratios

show how frequently sales are converted to cash and how quickly inventory is turned over Average collection period: Value of accounts receivable/value of average daily sales Ex. $52,000/$3510 = average of 14.8 days to collect Industry standards for collection times are key

Leverage ratios

show how much debt the venture has accumulated relative to assets or equity Debt ratio: Total liabilities/total assets Shows venture's ability to pay debts Ex. $13,600/$152,300 = 8.9% Favorable percentage depends on industry

Acquisition financing (leveraged buyout financing) -

used for acquiring other companies, either by buying outright, buying out present owners, or buying out stockholders to become a private company

Factor approach

uses earnings, dividend-paying capacity, and book value, assigns each a weight, and uses these to generate a valuation Similar to earnings approach, but considers other factors

Book value

uses net value of the venture's tangible assets to determine valuation Useful for new ventures, ventures with highly unpredictable earnings, or when sole owner has died Reflects value of assets, depreciation/appreciation, inventory adjustments, and accounts for intangible assets that cannot be sold

Research and development limited partnerships

venture develops technology using funds from a limited partnership of individual investors Most common in high-tech ventures Shares risk and rewards for a potential technology that involves significant risk and expense Contract between the venture and the limited partnership specifies how the funds will be used and how the limited partnership will be compensated Generally a fixed fee or cost-plus arrangement Contract generally specifies that liability and tax advantages will both be shared between the venture and the limited partnership Three steps: Funding (drawing up a contract and investment being made) Development (research performed using investment funds) Exit (technology is commercialized)

•Negotiation outcomes

•Reservation point Point at which you are indifferent about continuing with this negotiation or walking away Determined by your BATNA •Aspiration point- •Ideal outcome •Ask for more than you hope to get •Why?

Research and development limited partnerships advantages

minimizes amount of equity given up Reduces risk to the venture Strengthens financial statements, can help to attract additional outside capital

Acid test ratio

Current assets - inventory) current liabilities More rigorous test of liquidity - doesn't assume inventory can be quickly converted to cash 1:1 ratio is considered favorable in most industries

Lending crowdfunding

Kiva, Go Fund Me, etc. Allow ventures to take on debt financing outside of traditional commercial banks Often small loan amounts used for short-term needs like inventory buildup

Government grants - other types

Other grant opportunities from federal, state, or local governments May be available for a variety of purposes depending on the needs of the state/region offering the grant opportunity E.g., paying up to 50% of the first-year salary for a newly-hired employee in a region with a labor surplus Or offering tax reductions for locating or building facilities in a given region

Types of venture capital firms

Small business investment companies (SBICs) - small companies that receive government funds to invest in startups and growing small businesses Approximately 360 in operation currently, include a significant number of minority small business investment companies that specialize in ventures run by members of minority groups

Disadvantages to using external sources of funds?

Time-consuming. Generally 2-6 months to raise any form of outside capital May negatively affect drive for sales and profits - outside capital can substitute for generating operating income May lead to ill-advised spending (excessive hiring, moving into unnecessarily expensive facilities, etc.) Decreased flexibility and control - outside equity investors have influence over the direction of the venture Pressure for rapid growth - too much emphasis on short-term performance so investors can see a return on investment, may compromise long-term success of the venture

Private financing - funds from private investors ("angels")

Usually take an equity position in the venture, so get to have influence over its direction and decisions Some private investors may want to be actively involved in managing the venture, others not so much Important consideration for entrepreneur

Agreement on general terms

VC firm and entrepreneurs agree to broad terms of the funding agreement Does the potential deal make enough sense to justify additional time and resource commitment to do due diligence?

Final approval -

VC firm drafts an internal memorandum detailing the findings from due diligence Used to prepare formal legal documents that will govern the finalized deal between the VC firm and entrepreneurs

equity financing

Venture receives funds in exchange for a share of the ownership in the venture Does not require collateral - the investor's ownership stake in the venture serves a similar purpose Investor shares in the venture's profits and disposition of its assets (based on percentage of ownership) consider: availability of funds and assets, interest rates, desire to maintain control Often a combination of debt and equity financing will be used Can have multiple owners (private investors, venture capitalists, etc.) when launching a larger venture

Research and development limited partnerships disadvantages

expensive and time-consuming to create High failure rate Significant loss of control of the technology Exit process can be complicated and expensive

Profitability ratios:

show how profitable the venture is, and likely return on investment for investors Net profit margin: Net profit/net sales Ex. $16,300/$1,264,000 = 1.3% Industry standards are important, and also net profit will be lower for new ventures (and often negative)

Seed capital

small amount of capital needed to generate proof of concept or market feasibility research

Startup financing

used for initial product development and marketing (no commercial sales yet) Both can be hard to obtain, venture capitalists generally have minimum of $1 million funding level Might use angel investors or family/friends

Industry-sponsored venture capital -

- vC divisions of major corporations Example from earlier this semester: 3M Generally invest in ventures that develop technology in the industry the corporation operates in Geographically-oriented venture capital funds - funds designed to invest in ventures in a particular area (usually a state) Usually required to invest a certain percentage of capital in ventures within the designated state

Liquidity ratios

used to measure short-term solvency of the venture (i.e., how capable is it of meeting its short-term debts?) Current ratio: Current assets/current liabilities 2:1 ratio generally considered favorable, but specific industry may have slightly different standards

Ratio analysis

using figures from past financial performance to test the financial strength of the venture

Crowdfunding

what do you know about it? A way for multiple individuals to commit funds to projects or ventures they want to support

•Accessing some of these external growth resources (acquisition, joint venture, merger, leveraged buyout, franchise) may require a negotiationbetween the entrepreneur and another party

•A process in which two or more parties have different preferences and must attempt to agree on a joint decision •An interpersonal decision-making process necessary whenever we cannot achieve our objectives on our own •2 types: •Distributive (zero-sum/win-lose): Negotiation that seeks to divide a fixed amount •Integrative (nonzero-sum/win-win): Negotiation that seeks to create value and meet needs of all parties •Builds long term relationships •Both parties feel successful •Reduces divisions •Increases chance of cooperative bargaining in the future •Pareto efficiency: An economic state where resources are allocated in the most efficient manner. Exists when one party's outcomes cannot be improved without making another party's situation worse •Objective value •Did it reach pareto efficiency? •How were resources actually divided between the parties? •Subjective value •How did I do? •How do I feel about myself? Is my integrity intact? •Are my relationships w/other party intact? •Subjective value more predictive of long-term outcomes & satisfaction in organizations •BATNA: Best Alternative to Negotiated Agreement •Your BATNA gives you power in a negotiation. The better your BATNA, the easier it is to walk away from a negotiation. This often allows you to make the first offer, concede less, and secure more value

•Strategies for being an effective negotiator

•Consider the other party's situation - what is their strategy, whose interests do they need to satisfy, etc. •Can help understand and predict their behavior and frame solutions in terms of their interests •Have a concrete strategy - how important is the situation, what can be given up, how good is your BATNA, etc. •Begin with a positive overture - concessions can lead to concessions made by the other party •Address problems, not personalities - sticking to the issue, not personal characteristics of the other party •Don't pay too much attention to initial offers - remember anchoring and adjustment bias •Emphasize win-win solutions - don't assume all gains must come at the other party's expense, may be possible that a situation that seems distributive may actually be integrative

Joint ventures

A private sector company might also form a joint venture with a university to share costs and conduct research valued by both E.g., Westinghouse and Carnegie-Melon University to do robotics research - Westinghouse gets patent rights, CMU gets a percentage of royalties plus the right to publish research in academic journals One drawback - university researchers want to publish as much as possible of research results, but private sector partner wants to protect the intellectual property (through patents, trade secrets, etc.) - need to agree about what specific aspects of results can be published

What factors could influence the success of a joint venture?

Ability of management of the two firms to work well together Joint venture may fail without this, even if resources and knowledge combine well in theory Degree of alignment of the two firms' objectives and resources Obviously bad if two firms have conflicting objectives (e.g., some private sector-university ventures), but also bad if one firm perceives it is required to invest too much of its resources compared to the benefit it receives in achieving its objectives Realistic and shared expectations Bad if one of the firms expects the joint venture to fix all of its unrelated problems - both firms need to be on the same page about what the venture will actually accomplish Timing Some market conditions could be helpful for a joint venture, others not so much (similar to importance of timing in going pubic) Also, entering into a joint venture could prevent the firm from entering some markets, even though it allows entry into others

Advantages for the franchisor - we talked about a few of these previously

Ability to expand into new markets (and increase revenues) without taking on the risk of directly expanding into those markets And, cost savings - franchisee is putting up a significant proportion of the costs, and the franchisor can operate with fewer employees compared to a non-franchised business Economies of scale - because franchisees are often required to buy supplies and materials from the franchisor, franchisor can buy in very large quantities and achieve cost savings as a result And, savings in other areas due to shared costs with franchisees E.g., requirement that all franchisees contribute to a shared marketing and advertising fund

Leveraged Buyouts

Acquisition that takes place when an entrepreneur uses cash (acquired through a loan) to purchase an existing venture Often happens if the entrepreneur believes they can run the acquired company more efficiently than current owners Current owners may agree to a leveraged buyout if they are ready to retire or move on from their venture Funds for the leveraged buyout generally come in the form of long- term debt financing (generally 5+ years) Can come from banks, venture capital firms, insurance companies, etc. Debt:equity ratio for loans for a leveraged buyout may be as high as 5:1 to 10:1 - more risk than usual debt financing, but reflects belief that the entrepreneur will be able to generate increased sales and profits from the acquired company to repay the loan A good candidate for a leveraged buyout needs to have a reasonable asking price, sufficient debt capacity (because this is what is used to finance the buyout), and a favorable financial package (e.g., no dividend payments, ability to convert debt into common stock later)

Implications of growth

Actual firm growth - entrepreneur has the ability to transition to a more complex or professional management structure, and desires to grow the venture Most likely to achieve actual growth Unused potential for growth - entrepreneur has the ability to transition to a more professional management structure, but does not desire to grow the venture (potentially for lifestyle or work/life balance reasons) Low firm growth based on the entrepreneur's choice Constrained growth - entrepreneur desires to grow the venture, but does not possess the ability to transition to a more professional management structure Attempts to grow the firm may be frustrated, and venture may fail if the entrepreneur does not bring on a professional manager to handle the growth process Little potential for growth - entrepreneur does not have the desire to grow the venture or the ability to transition to a more professional management structure Firm may be most successful operating on a smaller scale, or may need to access external resources (e.g., joint ventures, acquisitions, mergers, etc.) if growth is desired later

Franchising

Arrangement where the sole manufacturer or distributor of a trademarked product/service (franchisor) gives another party (franchisee) the rights to distribute or retail the product or service, in exchange for royalty payments Advantages - mostly boil down to reduced risk for the entrepreneur Product is already accepted by customers, has credibility and reputation in its favor E.g., trying to acquire customers for a Subway franchise vs. a brand newsandwich shop Management support - franchisor generally provides training in management practices (accounting, personnel, marketing, production, etc.) and ongoing support E.g., McDonald's required school for franchisees Capital requirements - many costly startup functions are done by the franchisor (local market research, location analysis, etc.), and franchisor may also finance part of the startup cost Franchisees can also save on capital requirements by sharing expenses for advertising, sales promotions, etc. Advantages - mostly boil down to reduced risk for the entrepreneur Market knowledge - franchisor already has a good understanding of the target market, customer demographics, etc. that franchisee can access immediately without doing additional research Franchisors also update franchisees on important changes in national and local markets Standardization and control - franchisor identifies supplies and materials that meet its standards, so franchisee doesn't need to learn by trial and error Franchisee also benefits from standards for costs, inventory, cash flow, personnel, etc. that are set by the franchisor - again, don't need to learn by trial and error

Components of the pro forma balance statement

Assets- everything the business owns, the actual cost amount paid to acquire the asset. not necessarily the replacement cost or market value Cash, as well as anything else that will be converted into cash during the relevant period (within a year or less) A significant proportion of these kinds of assets will be receivables - money owed to the venture by customers Recall distinction between sales and receipts - sometimes customers will have time to pay for a completed sale Liabilities- everything the venture owes to creditors Current liabilities (due within the year) Long-term liabilities (due over a longer period of time) Balance of when to pay liabilities Paying bills as promptly as possible helps establish good credit and relationships with suppliers But, may sometimes want to delay payments to better manage cash flow (recall cash flow statement discussion) Owner Equity- total net worth of the venture (assets minus liabilities) Represents initial investments plus/minus profits/losses If multiple owners made initial investments, the amounts will be specified Revenue increases assets and equity Expenses decrease assets (or increase liabilities) and decrease equity Break-even analysis- shows the volume of sales that the venture will need to make to break even - make $0 profit and incur $0 loss Different from the month in the pro forma income statement that first shows a profit - why? Fixed costs for the remainder of the year still need to be paid at that point, regardless of whether additional sales are made Reflects total fixed costs divided by (selling price minus per- unit variable costs can represent graphically - at sales above the break- even point, revenue exceeds costs So any sales volume beyond that point results in profits Pro Forma Sources and applications of funds statement- ows how sources of funds, and net income were used I.e., to increase assets or pay off debts Helps readers to understand where necessary funds will come from, how it will be used, what happens to assets over time, etc. Shows initial investments, net income or loss, and adds back in depreciation (not an out-of-pocket expense) Sum represents total funds provided during the year Shows how funds were applied - equipment, inventory, etc. Shows how much total working capital increased or decreased during the course of the year

What do venture capital firms look for in investments?

Balance of risk and expected return in the portfolio Early-stage investments are higher risk, so higher return on investment is expected (approx. 50%)/ Later-stage/acquisition investments are lower risk, so lower return on investment is expected (approx. 30%) Some degree of control of the venture - at least 1 board seat Venture expected to run day-to-day operations, but VC firm has a role in big-picture decisions and supports with investment funds and expertise/ Trust and transparency between entrepreneur and VC firm is obviously important - expected to be a long (5+ year) relationship

SBA- Small Business Administration, guaranty loans- loans guaranteed by government, made through commercial banks.

Basic 7(a) Loan Guaranty- main type of SBA guaranty loans, available to small business that cannot obtain a standard business loan (a non-guaranteed loan) SBA provides guaranteed loans for uses like working capital machinery and equipment, land and buildings. Similar requirements as standard business loans-onstrated ability to repay based on cash flow, as well as character, capability, collateral, and owner's equity contribution All owners of at least 20% of the venture required to personally guarantee the loan Maximum loan amount of $5 million, and SBA will guarantee up to 85% of the loan amou Interest rates are negotiated, but have a maximum based on a certain amount above the prime (LIBOR) rate (ex. 7-yr fixed rate loan of 50,000 or more when prime interest rates are 4% can't be more than 6.25%) Lenders are charged a guaranty and servicing fee (helps offset the cost of the SBA loan programs, fee for the benefit of having the loan guaranteed) 504 loan program-provide fixed-rate financing for machinery and equipment (max 5.5 million) may come form a community development company 100% guaranteed Microloan 7m- short term loans of up to 50,000 for working capital, inventory, supplies 100% guaranteed

What's the alternative, if these disadvantages seem too significant?

Bootstrap financing - basically applying the internal sources of funds we talked about last week Using all possible methods to obtain and conserve cash Managing supplier and customer relationships to delay payments or speed up collection of receivables Taking advantage of supplier discounts for volume, cash payments, loyalty, etc. Consignment financing (paying for supplies in installments) Outsourcing any possible organizational functions to subcontractors But, obviously sometimes these methods may be insufficient to meet capital needs, and outside sources of funds may be necessary

Inventory turnover:

Cost of goods sold/value of inventory Ex. $632,000/$4,200 = 150.5x Higher ratio shows venture is able to sell inventory quickly (but,may be at risk of losing sales because inventory is understocked)

Research and development limited partnerships Exit stage can take one of three forms:

Equity partnership: venture and limited partnership form a new jointly-owned corporation limited partners' interest is converted to equity in the new venture, according to the terms of the contract Royalty partnership: venture pays a royalty (percentage of sales from the technology) to the limited partners Typically 6-10% Joint venture: venture and limited partners form a joint venture to produce products based on the developed technology Venture may be able to buy out partners at a specified time or sales volume

Venture capital

Finding and approaching a VC firm National Venture Capital Association (www.nvca.org) as well as regional venture capital associations Important to research each potential firm and make sure their portfolio goals are a good fit with the investment opportunity Having a referral can be very important - estimate that 80% of funded investments were from referrals Introduction from an accountant, lawyer, banker, etc. can be very influential Need to send business plan (or at least executive summary) with a short introductory letter Need to prepare an oral presentation if business plan results in interest - covering many aspects of the executive summary First impressions very important - decision making biases likely to be influential

internal sources of funds

Funds coming from one of many sources within the venture: Profits, sale of assets, reduction in working capital, accounts receivable, etc. Frequently used in the early stages of a venture Most if not all profits are put back into the venture (including no expectation of payback of outside equity investors) Renting assets when interest rates are low and/or rental terms are favorable (e.g., lease or option to buy) Outsourcing activities whenever possible All of these can conserve scarce cash to help maintain solvency and prevent cash flow problems other methods may involve creative management of supplier and customer relationships Getting extended payment terms from suppliers to help with cash needs in a 30-60 day period Collecting accounts receivable from suppliers more quickly Perhaps offering a discount for meeting the expedited payment deadline In either case, though, need to balance benefits of these methods with potential for straining the relationship with the supplier or customer External sources of funds: any funds that come from sources outside the venture itself E.g., self, friends and family, commercial banks, government loans, private financing, private offerings

Valuing the venture

If a VC firm is interested in investing, they will want to agree to general terms (e.g., how much investment for what proportion of equity) This requires a shared understanding of how much the venture is worth - how might the entrepreneur assess the overall value of the venture? Many factors are relevant: History of the venture - SWOT analysis factors Outlook of the general economy and specific industry How has the venture performed compared to other companies in its industry? Is the venture's market growing, declining, or stable? Book value of the venture/overall financial condition Acquisition cost (minus depreciation) minus liabilities But, standard depreciation formulas for assets (plant, land, equipment, etc.) can be too conservative and reflect a lower value than would be realistic - need to account for this Balance sheets and profit/loss statements from last 3 years can help provide justification for valuation Future earning capacity More recent years weighted more heavily than earlier years - not just an average of prior year earnings Income broken down by product line to show particularly promising products for future earnings Dividend-paying capacity - generally won't be expected to pay dividends right away, but need to assess potential for dividend payments in later years Goodwill and intangible assets - subjective factor, but tangible assets can help to document Any previous sales of equity - what were the prices for those sales? Have economic/financial considerations changed since then? Market price of equity for similar types of ventures If there are publicly-traded firms that do similar types of business, what is the value of their stock? Obviously depends on how similar those companies are to the venture, though

Pressure on the entrepreneur's time

In general, effective time management requires attention to several principles Principle of desire - basically, realizing that there is a need to change how the entrepreneur spends time, and it will require self-discipline Principle of effectiveness - requirement that the entrepreneur spend time on the most important tasks, complete them in a single session, and not be a perfectionist with any particular task Principle of analysis - entrepreneur needs to understand how time is currently being spent and areas where it is not used effectively Principle of teamwork - recognizing that it's not possible to perform all tasks as the venture grows - need to delegate Principle of prioritized planning - categorizing task in terms of importance and making sure the most important tasks are completed Principle of reanalysis - need to continually review time management and address areas where time is spent ineffectively

VC ownership %

Investment amount x desired multiple Projected year 5 profits x Price/earnings multiple of comparable firm Investment amount $500,000, projected year 5 profits = $650,000, desired VC multiple = 5x, price/earnings multiple of comparable company = 12 VC ownership % = Investment amount x desired multiple Projected year 5 profits x Price/earnings multiple of comparable firm VC ownership % = $500,000 x 5 $650,000 x 12 VC ownership % = $2,500,000 $7,800,000 VC ownership % = 32%

Anther type of financing available from commercial banks is cash flow financing. Also known as conventional bank loans (not asset-based)

Line of credit !!!- very commonly used. entrepreneur pays a "commitment fee" to have access to a line of credit that can be used as needed. Commitment fee ensures the bank will make the loan when it's needed and requested. Entrepreneur then pays interest on borrowed funds Generally comes with an agreement the loan will be paid down to a certain level within an specified time period Installment loans - short-term funds borrowed to cover operating costs for a specific period of time (e.g., seasonal financing needs) May be a better option for a venture with a proven record of generating sales and profits Usually 30-40 day loan period Straight commercial loans - Hybrid type of installment loan - funds are advanced to entrepreneur for 30-90 days Tend to be used for seasonal financing or inventory buildup Self-liquidating" - proceeds the loan is used to generate will be used to repay the loan character loans- personal loan made to the entrepreneur when the venture can't support a different type of loan ex. usually require collateral( vehicles, houses, land) and/or cosigner.

A few approaches to minimizing pressure on financial resources:

Managing cash flow - creating monthly (or weekly/daily, for some types of ventures) cash flow statements and comparing budgets and pro forma statements to actual results Can identify problems, and use sensitivity analysis (i.e., what happens if actual cash flow is worse than projected?) to be prepared for any potential shortfalls Can give an accurate and updated picture of available cash and determine potential problems with cash management Managing inventory - appropriate inventory levels are a delicate balance Too much inventory means too many resources are tied up in inventory (and costs for manufacturing, transportation, and storage will increase) Too little inventory may mean lost sales - products not available to customers when they want to buy them Computerized inventory systems can give an updated picture of how much inventory is available at any given time Working with customers and suppliers and understanding likely customer needs can help prevent too much or too little inventory Managing fixed assets - equipment, land, plant, etc. As discussed previously - renting or leasing when possible can free up cash for growth and other demands Managing costs and profits - comparing actual costs (direct and indirect) with projected amounts and determining where actual costs are higher than anticipated When actual costs exceed expectations, need to determine whether a given cost category can be reduced, or if prices need to be increased to resolve cash flow issues that result May need to understand specific costs for each particular product line to identify whether a particular product (or customer category) is causing particular problems for financial resources as a result of growth Tax considerations - need to account for employment taxes and federal and state income taxes Have to withhold federal and state employment taxes for each employee (total cash burden increases as number of employees grows) Deposits aren't made for these requirements (e.g., state and federal taxes, Social Security taxes, Medicare taxes) - need to make sure these funds aren't used for other purposes to avoid incurring high interest and fees for late deposits Need to be budgeted for - can affect cash flow and profits End of year tax returns for federal and state taxes also need to be filed - specific type and amount depends on type of ownership plan Using an external tax/accounting service or specialized bookkeeping software can help to make sure tax responsibilities are managed appropriately

Another option, if no family members are interested in taking over the business: transferring ownership to a non-family member

May be a long-term employee who is familiar with the business and has the desire to take it over Can make for a smoother transition due to the new owner's knowledge and familiarity with the venture Will need to train the employee to act as ownership, and determine how much equity the current owner will retain May become a minority owner, stockholder, advisor, etc. Alternatively, existing owner may retire from their role as active owner and decide to hire a manager to run the venture, but retain ownership New owner likely has less knowledge and familiarity with the venture in this case, so good fit and clear job description are key

One option: transfer the venture to family members

May want to keep the business in the family, but this can often be unsuccessful - only 30% surviving in the second generation and 12% into the third generation Could be because of insufficient planning, lack of training or experience on part of new owner, interpersonal problems within the family or resentment on the part of employees, etc. Need to consider the role of the original owner (should ideally stay involved for a while to advise and support the transition), how to handle reactions of loyal employees, income and tax considerations for family members, etc.

Why might an acquisition not be the best approach?

Not a great track record of success - many acquisitions are not successful If a firm is up for sale, may mean that it hasn't been particularly successful Acquiring venture may be overconfident - recall discussion of decision-making biases Entrepreneur may overestimate their ability to turn the acquired firm around, or successfully merge cultures Loss of key employees - some of the value of the acquired firm is the knowledge and relationships of existing employees If they decide to leave when the acquisition occurs, much of the value of the acquisition may be lost Overvaluation - recall our discussion of valuation in making a deal with a VC firm - it's not an exact science If the acquisition costs too much, can significantly limit the potential return on investment

Three phases of government grants

Phase I - up to $100,000 for up to 6 months of experimental or theoretical research Goal is to determine the feasibility of the research and assess the venture's performance with a (relatively) small investment Phase II - main R&D effort - must have shown success and promise in Phase I to be considered for Phase II funds Up to $750,000 for 24 additional months of research Goal is to develop prototype products or services Phase III - commercialization stage - no direct funding from the government Prototypes developed in Phase II can be used to secure private sector funding or standard government contracts

growth can also create new challenges - what might a few of these be?

Pressure on management of employees: entrepreneur might need to let go of some control and decision-making from the early days of the venture Entrepreneur may have been the sole or primary decision maker in the beginning, but this might not be effective as the venture grows Entrepreneur may need to adopt a participative style of management - brings more knowledge and expertise to decisions, increases employees' investment and motivation, enhances job satisfaction for employees Necessary to delegate responsibilities that entrepreneur or management team previously handled, train employees to take on those responsibilities, and provide frequent feedback on how they're performing in new roles

Venture capital

Professionally managed pool of equity capital, generally coming from wealthy individuals or institutions in a limited partnership In addition to individual investors, might also include pension funds, endowment funds, foreign investors, etc. as investors Generally managed by a general partner (the VC firm itself), that receives a management fee and a percentage of investment gains Typically looks to make 5+ year investments in helping early stage ventures to grow and expand Or, finance leveraged buyouts of private companies or divisions of public corporations Venture capitalist firm gets an equity stake in the venture and plays an active role in managing the firm May also provide debt financing to the venture in addition to the equity investment

Venture capital funding process

Recall discussion of bank lending decisions - both objective and subjective considerations will be influential Preliminary screening - VC firm receives business plan from venture (may only need to review executive summary to determine it isn't a good fit) Does the proposal fit the VC firm's long-term goals and help with desired portfolio balance? What is the state of the venture's industry? Does the venture have reasonable potential to deliver required return on investment? Do the entrepreneurs and management team have the experience and capability to deliver on the business plan?

Some of the Rule D requirements include:

Sale of up to $5 million in securities in any 12-month period Can sell to up to 35 investors, but also an unlimited number of "accredited investors" Banks, investment companies, very wealthy individuals, general partners in the venture, etc. No general advertising through pubic media Disclosure of information (e.g., two years of financial statements) if any "unaccredited investors" are involved

pro forma balance sheet

Shows the overall position of the business at the end of the first year of operations. Summarizes assets, liabilities, and net worth of the venture. Can help to show the venture is solvent. (I.e., does the venture have assets that will be converted into cash within the year to pay liabilities that will come due within the year?) Prepared at periodic intervals (e.g., yearly or quarterly) Reflects the picture of assets and liabilities at a moment in time (rather than over a period of time)

3 key criteria VCs look for:

Strong management team with members with established skills and experience in the industry (Demonstrated commitment via personal investments and supportive family situations) Unique product with clear competitive advantage in a large, growing market (Marketing section of business plan key to show why the product better meets customer needs than existing products) Significant capital appreciation - how much will the value of the capital invested grow during the investment period?(Exact appreciation rate depends on size of deal, stage of development, risks, and exit options)

How should an acquisition be identified and structured to be successful?

The acquisition should allow for synergy - "the whole is greater than the sum of its parts" Resources and knowledge of the acquired firm need to combine well with those of the acquiring firm to allow it perform the functions of both better than they could be done independently Can get referrals for acquisition candidates from brokers, accountants, attorneys, bankers, consultants, business associates, etc. Obviously need to spend significant time and energy researching the acquisition candidate to determine if it's a good fit Deal structure - determining what assets will be acquired for what price and how and when the payment will be made Direct purchase - entrepreneur borrows funds to directly purchase acquired firm's existing stock and assets, and repays the loan over time from increased cash flow generated by the acquisition Bootstrap purchase - entrepreneur purchases a part of the acquired firm (e.g., 20-30%) and purchases the remainder over time out of the acquired firm's earnings

A second method for achieving growth through external resources - acquisitions

The venture purchases all or part of a second company If the entire company is purchased, it is completely absorbed into the acquiring venture, and doesn't exist independently anymore Might be a vertical acquisition (venture buys one of its suppliers or buyers) or a horizontal acquisition (venture buys a manufacturer of a competitive or complementary product) How could an acquisition be beneficial to growth? Acquired firm has an established track record and reputation Acquired firm's customers are already familiar with its location Acquired firm has an established marketing and sales structures Might be cheaper than the venture expanding into that area Existing employees have valuable knowledge and relationships More time can be dedicated to finding synergies and more ways to grow - don't need to "recreate the wheel"

Debt to equity ratio

Total liabilities/stockholder's equity Shows relative risk to creditors Ex. $13,600/$139,300 = 97.6x

Due diligence

VC firm conducts detailed review of the venture, its business plan, the target market, etc. Longest stage of the process - 1-3 months Assess potential for upside, risks, strength of competitors, availability of finances, suppliers, customers, etc.

external growth resources

We discussed a number of options for ways the venture could seek to grow using existing resources and structures E.g., by pursuing a penetration, product development, market development, or diversification strategy But, a venture could also seek to grow by accessing the resources of other people or firms Growth through accessing external resources could take the form of joint ventures, acquisitions, mergers, or franchising relationships First potential form of external resource-based growth: joint ventures Talked about this earlier in the semester when discussing international entrepreneurship - what do you remember about joint ventures? Basically, the entrepreneur/venture joins with another company to form a new, jointly-owned venture Most common form - joint venture between two private sector companies Boeing, Mitsubishi, Fuji, Kawasaki - joint venture to produce small aircrafts by sharing technology and costs Microsoft and NBC Universal - joint venture to create MSNBC by sharing costs

Disadvantages of franchising

We talked about disadvantages of being a franchisor previously - mainly, giving up control and potential revenue from expanding directly into a new market Also, if a particular franchisee does a poor job of managing their franchise, it can reflect negatively on the entire business E.g., customers having bad experiences with one franchise and moving their business away from the entire franchise system For franchisees, disadvantages include risk of franchisor not providing important services, advertising, and location support Also, risk of franchisor failing or selling the business - newownership group

Angel investors

Wealthy individuals who look to make equity investments in a wide range of venture types Typical investment amounts anywhere from $10,000 to $1,000,000 for all stages of funding, but particularly important for early stages Recall that venture capitalists probably aren't often a big source of funds at that stage Hard to estimate size of total investment pool accurately, but 1980 study shows 87% of private offerings were purchased by individual investors, with average investment of $74,000 More data from studies: angel investors averaged one deal every two years, with average investment amount of $50,000 (although 36% were less than $10,000) 40% of investments in startups, 80% ventures <5 years old 100,000 investors per year financing 30,000-50,000 ventures What kinds of people tend to become angel investors? Well-educated - many have graduate degrees Tend to finance relatively local firms and expect to play an active role in management of venture Market size is roughly the same as in venture capital, but fund about 8x as many ventures Makes sense - investment size is much smaller than those made by venture capitalists Often find their deals through referrals made by business associates, friends, personal research, etc.

going public-

entrepreneur and other equity owners of the venture offer and sell some part of the company to the public; u.s. process is governed by registration process overseen by the Securities and Change commission (SEC) pros- obtaining new capital- when a public offering is purchased on the public market, the venture obtains capital for variety of needs(working capital, plant/equipment, inventory) increased liquidity- ability to value and transfer ownership among family members, ability for VC firms to exist worth best possible return on investment improved ability to raise future funds cons- loss of control- (publicly-traded firms are accountable to public stockholders, who often want to see short term goals) increased reporting requirements- (need to disclose to the public all information relevant to the company and its operations and management additional diversion of attention and expenses(estimate of over 1 million in initial cost for going public) timing of going public- size, earning and financial performance, market conditions, urgency of funds needed, needs and desires of present owners process for going public- 1. file registration statement (Form s-1) 2. preliminary prospectus is sent to the underwriting group as a red hearing 3. statement is reviewed by SEC to check for deficiencies 4. underwriting syndicate 5. 2-10 months from filing registration statement to offering statement to become effective 6. 90 day quiet period prior to offering being made available after going public- 1. underwriting firm provides aftermarket supports to ensure the price of the stock doesn't fall below the initial offering price 2. venture will need to have a representative available to communicate with finical market analysts and brokers 3. venture will need to complacencies with annual (10-k) quarterly (10-Q) and transactions (8-k) reporting requirements

benefits would growth have for the venture?

increased profit and return for owners More efficient production (economies of scale) More bargaining power with suppliers (higher volume orders) Increased legitimacy of the firm - perceived by customers, lenders and investors, and other stakeholders as more stable/prestigious Overall, many aspects of running the venture can be conducted more flexibly and successfully as a result of growth

What to consider in deciding to take on debt financing?

interest rates - when low, may make more sense Worth it to pay some interest to retain ownership (compared to equity financing) More ownership = greater returns when venture becomes profitable Leverage (debt/total asset ratio) - if too high, can be hard to make interest payments Can inhibit growth and increase risk long-term debt financing (>1 year) generally used to help with a large purchase (e.g., machinery, land, a building, etc.) Part of the value of the asset (e.g., 50-80%) will often be used as collateral for this kind of loan

General valuation method

used to determine what percentage of the venture a VC firm will want to be given for a particular investment amount

strategies for growth

market penetration- focused on developing the success of an existing product in its existing market. trying to become more successful in the current market by encouraging existing customers to buy more of the current products. may rely heavily on marketing efforts to encourage repeat purchases does not require development of new products or attempts to reach new markets market development- focused on selling existing product to new group of customers (new markets) new markets could be in terms of geography, demographics of customers, or new uses of the product new geographic market strategies( selling the existing product in a new geographic area) new product use strategies product development- focused on achieving growth by developing and selling new products to existing customers can be effective and can capitalize on existing reputation diversification- focused on developing and selling new products in new markets forward integration diversification (going a step forward in the value chain) good bc related to firm existing knowledge base and opportunities for synergy (easier and more efficient transactions with supplier or buyer) and provides opportunities for new knowledge related to product value chain horizontal integration ( expanding into the value chain for a new product but at the same vertical level as the current products value chain / ex washing machines to laundry detergent)

Debt financing

money is borrowed and repaid with interest Typically in the form of a loan Usually requires some asset be used as collateral E.g., a car, house, inventory, machinery, land, etc. Short-term debt financing (<1 year) may be used to provide working capital for things like inventory, accounts receivable, or other operating expenses long-term debt financing (>1 year) generally used to help with a large purchase (e.g., machinery, land, a building, etc.) Part of the value of the asset (e.g., 50-80%) will often be used as collateral for this kind of loan

Earnings approach

most widely used approach - gives an investor the best estimate of likely return on investment Weights most recent years' earnings most heavily to determine potential earnings, then calculates a price- earnings multiple based on industry standards and risk level Multiple is higher if the venture is high-risk, lower if venture is low-risk Ex. Weighted earnings of $0.6 million, venture is low risk, industry standard is 7, valuation = $0.6 million x 7 = $4.2 million

Management buyout -

owner sells the firm to a certain number of key employees, but without the complex, long-term agreement used in an ESOP Similar to a direct sale, but buyers are existing employees of the venture Sale price depends on valuation process similar to what we discussed in getting investment from a VC firm May be difficult for new owners to pay cash for the purchase of the venture - may use a bank loan, old owner may carry the note and allow repayment over time, or new owners may sell their own stock to outside investors to raise funds for the purchase In any case, expectation is that new owners will be able to repay obligations out of revenues from the venture, as it is continuing with much of the same management team in place

Direct sale

owner sells the venture outright to a larger company (potentially as part of a growth strategy) or other entrepreneur who believes it can run it effectively Purchase agreement is important - if based on notes that will be repaid from future profits, owner may not receive a cash payment if the new owner fails And, be left taking back a struggling venture Role of the original owner may vary - may be asked to sign a noncompete agreement for that industry for a certain number of years, may be asked to stay on in a transition capacity under a specified employment contract, etc. - depends on goals and preferences of new owners

Employee stock option plan (ESOP) -

owner sells the venture to its current employees, structured over time ESOP creates a new legal entity - employee stock ownership trust - that borrows money against venture's future profits and buy's owner's shares over time Shares are distributed to individual employees' retirement accounts over time, as the loan is repaid Owner is repaid the loan amount plus interest Good form of retaining employees' loyalty and motivation - they are now personally incentivized to help the venture succeed, as they own increasing percentages of the venture's equity