Introduction to Entrepreneurship Chapter 8 Mindtap

evaluation process typically takes place in stages. The four most common stages follow.

:Stage 1: Initial Screening This is a quick review of the basic venture to see if it meets the VC's particular interests. Stage 2: Evaluation of the Business Plan A detailed reading of the plan is done to evaluate the factors mentioned earlier. Stage 3: Oral Presentation The entrepreneur verbally presents the plan to the VC. See Table 8.5 for a thorough understanding of the key elements necessary in presenting to a VC. Stage 4: Final Evaluation: After analyzing the plan and visiting with suppliers, customers, consultants, and others, the VC makes a final decision. This four-step process screens out approximately 98 percent of all venture plans. The rest receive some degree of financial backing.

Equity financing

involves the sale of some of the ownership in the venture. Debt places a burden on the entrepreneur of loan repayment with interest, whereas equity financing forces the entrepreneur to relinquish some degree of control

The business plan is a critical element in a new-venture proposal and should be complete, clear, and well presented. VCs generally will analyze five major aspects of the plan:

the proposal size, financial projections, investment recovery, competitive advantage, and company management.

The use of debt

to finance a new venture involves a payback of the funds plus a fee (interest) for the use of the money.

Sophisticated investors

Wealthy individuals who invest more or less regularly in new and earlyand late-stage ventures. They are knowledgeable about the technical and commercial opportunities and risks of the businesses in which they invest.

informal risk capitalists

Wealthy people in the United States are looking for investment opportunities; they are referred to as business angels or informal risk capitalists.

business angels

Wealthy people in the United States looking for investment opportunities.

accredited purchaser

A category used in Regulation D that includes institutional investors; any person who buys at least $150,000 of the offered security and whose net worth is in excess of $1 million; a person whose individual income was greater than $200,000 in each of the last two years; directors, partners, or executive officers selling securities; and certain tax-exempt organizations with more than $500,000 in assets.

initial public offering (IPO)

A corporation's raising of capital through the sale of securities on the public markets.

private placement

A method of raising capital through securities; often used by small ventures.

Venture Capitalists' Due Diligence "Deal Killers"

An arrogant management team. This is a team that will not listen, or one that has displayed a lack of integrity or is preoccupied with complete control. No defendable market position. This occurs when there is no identified intellectual property to defend or any specific market niche to occupy. Excessive founder salaries. If the focus seems to be on the founders' distributing the proceeds to themselves quickly (or bonuses), then there is a problem of commitment to the venture. Vulnerability of the founder. Whenever there is overdependence on one person (a particular founder) for her skills or persona, there could be a major issue. Yesterday's news. If a business plan is perceived as "overshopped" or simply presented too much over a short period of time, then it may be perceived as an "old idea." Ignorance of the competitive landscape. Whenever the team lacks the understanding of the real strengths and weaknesses of the competition, a major red flag goes up for the VC. Unrealistic expectations. A typical problem of entrepreneurs is their lack of understanding of the valuation of their venture and the deal terms involved in the VC investment proposal. Usually the entrepreneurs think that their venture is worth far more than the VC does.

Pros with Angel Investors

Angels engage in smaller financial deals. Angels prefer seed stage or start-up stage. Angels invest in various industry sectors. Angels are located in local geographic areas. Angels are genuinely interested in the entrepreneur.

Cons with Angel Investors

Angels offer no additional investment money. Angels cannot offer any national image. Angels lack important contacts for future leverage. Angels may want some decision making with the entrepreneur. Angels are getting more sophisticated in their investment decisions.

Finance companies

Asset-based lenders that lend money against assets such as receivables, inventory, and equipment.

debt financing

Borrowing money for short- or long-term periods for working capital or for purchasing property and equipment.

These experienced professionals provide a full range of financial services for new or growing ventures, including the following.

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

major types of financing encountered in the search for capital

Commercial loans, public offerings, private placements, convertible debentures, venture capital, and informal risk capital

Peer-to-peer lending

Commonly abbreviated as P2PL is the practice of lending money to unrelated individuals, or "peers," without going through a bank or other traditional financial institution. Also known as "debt-based crowdfunding" this lending takes place online on peer-topeer lending companies' websites using various different lending platforms.

Angel investors can be classified into five basic groups:

Corporate angels. Typically, so-called "corporate angels" are senior managers at Fortune 1000 corporations who have been laid off with generous severances or have taken early retirement. In addition to receiving the cash, an entrepreneur may persuade the corporate angel to occupy a senior management position. Entrepreneurial angels. The most prevalent type of investors, most of these individuals own and operate highly successful businesses. Because these investors have other sources of income, and perhaps significant wealth from IPOs or partial buyouts, they will take bigger risks and invest more capital. The best way to market your deal to these angels, therefore, is as a synergistic opportunity. Enthusiast angels: Whereas entrepreneurial angels tend to be somewhat calculating, enthusiasts simply like to be involved in deals. Most enthusiast angels are age 65 or older, are independently wealthy from success in a business they started, and have abbreviated work schedules. For them, investing is a hobby. Micromanagement angels. Micromanagers are very serious investors. Some of them were born wealthy, but the vast majority attained wealth through their own efforts. Unfortunately, this heritage makes them dangerous. Professional angels. The term professional in this context refers to the investor's occupation, such as doctor, lawyer, and, in some very rare instances, accountant. Professional angels like to invest in companies that offer a product or service with which they have some experience.

In addition, many new ventures have begun to recognize some other disadvantages of going public:

Costs. The expenses involved with a public offering are significantly higher than for other sources of capital. Accounting fees, legal fees, and prospectus printing and distribution, as well as the cost of underwriting the stock, can result in high costs. Disclosure. Detailed disclosures of the company's affairs must be made public. New-venture firms often prefer to keep such information private. Requirements. The paperwork involved with SEC regulations, as well as continuing performance information, drains large amounts of time, energy, and money from management. Many new ventures consider these elements better invested in helping the company grow. Shareholder pressure. Management decisions are sometimes short term in nature to maintain a good performance record for earnings and dividends to the shareholders. This pressure can lead to a failure to give adequate consideration to the company's long-term growth and improvement.

Trade credit

Credit given by a supplier who sells goods on account. A common arrangement calls for the bill to be settled within 30 to 90 days.

Key Questions or Evaluating a VC Firm

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

Another set of researchers developed 28 of these criteria, grouped into six major categories:

Entrepreneur's personality Entrepreneur's experience Product or service characteristics Market characteristics Financial considerations Nature of the venture team

a number of major trends have occurred in venture capital over the last few years.

First, the predominant investor class is changing from individuals, foundations, and families to pension institutions. Therefore, sources of capital commitments will continue to shift away from the less-experienced venture capital firm (less than 3 years) to the more-experienced firm (greater than 3 years). Second, innovation has become more global and is no longer the exclusive domain of Silicon Valley and Route 128 in Boston. Therefore, many VCs have opened offices in China, India, Israel, and Vietnam Third, funds are becoming more specialized and less homogeneous. The industry has become more diverse, more specialized, and less uniform than is generally thought. Sharp differences are apparent in terms of investing objectives and criteria, strategy, and focusing on particular stages, sizes, and market technology niches. Fourth, syndicated deals are emerging. Accompanying this specialization is a new "farm team" system. Large, established venture capital firms have crafted both formal and informal relationships with new funds as feeder funds. Often, one general partner of the established fund will provide time and know-how to the new fund. Fifth, small start-up investments have weakened over the last decade. Many venture capital firms have experienced challenges with some of the high-risk ventures in today's technological environment in their portfolios. Sixth, the industry has become more efficient and more responsive to the needs of the entrepreneur as a result of greater professionalism and greater competition. Now most VCs view themselves as service providers whose job is to provide advice and counsel, which adds more value to the enterprise than just cash. Seventh, the trend is toward a stronger legal environment. The heated competition for venture capital in recent years has resulted in a more sophisticated legal and contractual environment. The frequency and extent of litigation are rising. Finally, corporate venture capital is on the rise among major corporations. The advantages are clear for entrepreneurs because the parent companies can offer strategic and tactical advice, an operating budget, credibility, and validation with a well-known investor name, access to parent company's information technology talent, potential sales to the parent company, more confidence for follow-on funding, ability to tap into global connections and in-house expertise, and a potential exit path for the venture.

Although the use of P2P lending provides many immediate advantages for entrepreneurs in start-up mode, potential dangers include the following:

Funding success rate. Most loans are difficult to complete; so the funding success rate could be questionable. Business plan disclosure. The entrepreneur's business plan is now released to the public domain. No ongoing counseling relationship. The entrepreneur does not receive any advice or gain experience from the lender, and there are no future rounds of lending or investment. Potential tax liability. There are tax implications for the borrower and lender. Uncertain regulatory environment. The SEC continues to review these sites for potential regulatory policies.

Crowdfunding may serve as a viable vehicle for raising those early seed-stage dollars. Crowdfunding campaigns provide entrepreneurs with a number of benefits:

Funding: Access to smaller amounts of funding that major investors usually ignore Profile: Raises the new venture's reputation Marketing: Demonstrates there is an interested market for the venture Engagement: Creates a forum to engage with audiences Feedback: Offers an opportunity to beta-test with access to market feedback

Public Offerings

Going public is a term used to refer to a corporation's raising capital through the sale of securities on the public markets. Following are some of the advantages to this approach. Size of capital amount. Selling securities is one of the fastest ways to raise large sums of capital in a short period of time. Liquidity. The public market provides liquidity for owners since they can readily sell their stock. Value. The marketplace puts a value on the company's stock, which in turn allows value to be placed on the corporation. Image. The image of a publicly traded corporation often is stronger in the eyes of suppliers, financiers, and customers.

Venture capitalists

Individuals who provide a full range of financial services for new or growing ventures, such as capital for start-ups and expansions, marketing research, management consulting, assistance with negotiating technical agreements, and assistance with employee recruitment and development of employee agreements.

angel capital

Investments in new ventures that come from wealthy individuals referred to as "business angels."

direct public offerings (DPOs)

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

crowdfunding

It is a twenty-first century phenomenon. Commercial lenders are not always willing to make loans to unproven enterprises, leaving entrepreneurs desperate for funding to seek new loan options.

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

Loan with warrants provides the investor with the right to buy stock at a fixed price at some future date. Terms on the warrants are negotiable. The warrant customarily provides for the purchase of additional stock, such as up to 10 percent of the total issue at 130 percent of the original offering price within a five-year period following the offering date. Convertible debentures are unsecured loans that can be converted into stock. The conversion price, interest rate, and provisions of the loan agreement are all areas for negotiation. Preferred stock is equity that gives investors a preferred place among the creditors in the event the venture is dissolved. The stock also pays a dividend and can increase in price, thus giving investors an even greater return. Some preferred stock issues are convertible to common stock, a feature that can make them even more attractive. Common stock is the most basic form of ownership. This stock usually carries the right to vote for the board of directors. If a new venture does well, common-stock investors often make a large return on their investment. These stock issues often are sold through public or private offerings.

bootstrapping techniques to keep in mind:

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

Dispelling Venture Capital Myths

Myth 1: Venture Capital Firms Want to Own Control of Your Company and Tell You How to Run the Business Myth 2: Venture Capitalists Are satisfied with a Reasonable Return on Investments Myth 3: Venture Capitalists Are Quick to Invest Myth 4: Venture Capitalists Are Interested in Backing New Ideas or High-Technology Inventions—Management Is a Secondary Consideration Myth 5: Venture Capitalists Need Only Basic Summary Information before They Make an Investment

Advantages of Debt Financing

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

Disadvantages of Debt Financing.

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

Elements of the old Regulation A that remain the same for offerings under the proposed Regulation A+ are that the securities issued may be sold publicly by means of a general solicitation and will be freely tradable subject to certain restrictions and the civil liability provisions of the Securities Act. You must identify which of the two tiers applies to the offering:

Regulation A Tier 1: Offerings up to $20 million in a 12-month period, with no more than $6 million in offers by the selling security-holder that are affiliates of the issuer Regulation A Tier 2: Offerings up to $50 million in a 12-month period, with no more than $15 million in offers by the selling security-holders that are affiliates of the issuer

Regulation D

Regulation and exemption for reports and statements required for selling stock to private parties based on the amount of money being raised.

Therefore, it is wise for any entrepreneur to be aware of the potential concerns that still exist with crowdfunding:

Reputation. Reaching financial goals and successfully gathering substantial public support but being unable to deliver on the venture could have a negative impact. IP protection. Concerns exist about idea theft and protecting intellectual property. Donor dilution. If the same network of supporters is reached out to multiple times, they will eventually tire of the necessary support. Investor management. The entrepreneur must manage investors, which is time-consuming. Public fear. Without a proper regulatory framework, the likelihood of a scam or abuse of funds is high.

The SCOR process is easy enough for a small business owner to complete with the assistance of a knowledgeable accountant and attorney. Regulation D defines three separate exemptions, which are based on the amount of money being raised. Along with their accompanying rule, these exemptions follow.

Rule 504—placements up to $1 million. No specific disclosure/information requirements and no limits on the kind or type of purchasers exist. This makes marketing offerings of this size easier than it was heretofore. Rule 505—placements of up to $5 million. The criteria for a public offering exemption are somewhat more difficult to meet than those for smaller offerings. Sales of securities can be made to not more than 35 nonaccredited purchasers and to an unlimited number of accredited purchasers. If purchasers are nonaccredited as well as accredited, then the company must follow specified information disclosure requirements. Investors must have the opportunity to obtain additional information about the company and its management. Rule 506—placements in excess of $5 million. Sales can be made to no more than 35 nonaccredited purchasers and an unlimited number of accredited purchasers. However, the nonaccredited purchasers must be "sophisticated" in investment matters. Also, the specific disclosure requirements are more detailed than those for offerings between $500,000 and $5 million. Investors must have the opportunity to obtain additional information about the company and its management.

Accounts receivable financing

Short-term financing that involves either the pledge of receivables as collateral for a loan or the outright sale of receivables. (See also Factoring.)

Recently, however, VCs have increased investments in early-stage funding due to number of reasons:

The ease and efficiency to launch a venture, get the product to market, and reach larger markets than ever before. The huge increase in incubators and accelerators that work with the ventures to increase their value. Sharp reductions in infrastructure costs because of cloud-based computing. Shorter product cycles and iterative development processes. Selling to global consumers has become feasible for start-up entrepreneurs who can access much larger markets through the Internet. The dramatic impact that equity crowdfunding has had on early stage investing. College graduates have more sophisticated knowledge about some of the most important technological developments, such as mobile, social, and cloud.

Factoring

The sale of accounts receivable.

Equity financing

The sale of some ownership in a venture in order to gain capital for start-up.

Researcher Dean A. Shepherd developed a list of eight critical factors that VCs use in the evaluation of new ventures, as follows:

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

To secure a bank loan, entrepreneurs typically have to answer a number of questions.

What do you plan to do with the money? Do not plan on using bank loans for high-risk ventures. Banks typically lend only to the surest of all possible ventures. How much do you need? Some entrepreneurs go to their bank with no clear idea of how much money they need. All they know is that they need cash. The more precisely an entrepreneur can answer this question, the more likely the loan will be granted. When do you need it? Never rush to a bank with immediate requests for money. Poor planners never attract lenders. How long will you need it? The shorter the period of time entrepreneurs need the money, the more likely they are to get loans. The time at which the loan will be repaid should correspond to some important milestone in the business plan. How will you repay the loan? This is the most important question. What if plans go awry? Can other income be diverted to pay off the loan? Does collateral exist? Even if a quantity of fixed assets exists, the bank may be unimpressed. Experience dictates that assets sold at liquidation command only a fraction—5 to 10 cents on the dollar—of their value.

The study found that entrepreneurs' success with acquiring funding is related to four general, variable categories:

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