Entrepreneurial Finance Final Exam
Implicit Versus Explicit Financial Capital Costs
- Formal historical accounting procedures include explicit records of debt (interest and principal) and dividend costs of equity capital - However, no provision is made to record the less tangible expenses of equity capital (i.e., required capital gains to complement the dividends)
Organizing The Fund: VC Fund Placement Memorandum:
- Frontmatter Declarations - State Securities Disclosures - Offering Summary - Fund Overview - Executive Summary - Summary of Terms
Harvesting (or Exiting) Your Business
The process of exiting the privately held business venture to unlock the owners' investment value
Succession Planning in Family-Owned Businesses
Entrepreneurs who head family-owned firms face special problems
Balance Sheet Insolvency
Exists when total liabilities exceeds total assets
Rapid Growth
If the decision is to growth, need sufficient resources to finance growth
Market Exploitation
In this method, you attempt to increase sales by using more effective marketing strategies with the current target market
Market Exploration
In this method, you seek out new markets, approaches, products or distribution channels
Outsourcing with Independent Contractors
Independent contractors (ICs) are not employees, but own their own businesses and are hired by you to do a specific job
Operations Restructuring
Involves growing revenues relative to costs and/or cutting costs relative to the venture's revenues
Planning for Harvest and Exit
Many entrepreneurs are not concerned with how they will get out of the business
True or False? During startup, your main concerns are to ensure sufficient capital, seek customers and design a way to deliver your product or service
True
How does a Venture Capitalist get paid? : Two and Twenty Shops
VC investment management firms having a contract that gives them an annual 2% fee on invested capital and a 20% carried interest from the proceeds of selling portfolio companies.
Estimating the Cost of Equity: Publicly Traded Stock Investors
equity investors of firms whose stocks trade in public markets such as the over-the-counter market or an organized securities exchange
Loan default
failure to meet loan interest or principal payments when due
Due Diligence and Active Investing: VC Fund Management: Deal flow
flow of business plans and term sheets involved in the venture capital investing process
Interest Rate Relationships: rf = RR + IP
for debt by effectively default-free borrowers (e.g. U.S. government)
Determining Cost Of Debt Capital: Real Interest Rate (RR)
interest one would face in the absence of inflation, risk, illiquidity, and any other factors determining the appropriate interest
Determining Cost Of Debt Capital: Prime Rate
interest rate charged by banks to their highest quality (lowest default risk) business customers.
Determining Cost Of Debt Capital: Risk-free Interest Rate (rf)
interest rate on debt that is virtually free of default risk
Asset Restructuring
involves improving the working capital to sales relationship and/or selling off fixed assets
Estimating the Cost of Equity: Private Equity Investors
owners of proprietorships, partners in partnerships, owners in closely held corporations and members in LLCs
Involuntary Bankruptcy Petition
petition for bankruptcy filed by the venture's creditors (bank and venders file Chapter 7 for liquidation purposes)
Voluntary Bankruptcy Petition
petition for bankruptcy filed by the venture's management (founder and management team file Chapter 11 for reorganization purposes)
How does a Venture Capitalist get paid? : Carried Interest
portion of profits paid to the professional venture capitalist as incentive compensation - from the proceeds of selling their investments in portfolio companies.
Debt payment extension
postponing due dates for interest and principal payments on loans (bank debt) and payments on credit purchases (venders)
Determining Cost Of Debt Capital: Maturity Premium (MP)
premium to reflect increased uncertainty associated with long-term debt
Determining Cost Of Debt Capital: Interest Rate
price paid to borrow funds
Due Diligence and Active Investing: VC Fund Management: Due diligence (in venture investing context)
process of ascertaining the viability of a business plan
Due Diligence:
process of ascertaining, to the extent possible, an issuing firm's financial condition and investment intent
Leveraged Buyout (LBO)
purchase price of a firm is financed largely with debt financial capital
Determining Cost Of Debt Capital: Bond Rating
reflects the default risk of a firm's bonds as judged by a bond rating agency
Determining Cost Of Debt Capital: Inflation
rising prices not offset by increasing quality of the goods or services being purchased
Determining Cost Of Debt Capital: Default Risk
risk that a borrower will not pay the interest and/or principal on a loan
Primary Offering:
sale of new securities
Secondary Offering:
sale of used securities
Debt composition change
when creditors reduce (or write-off) some of their contractual claims against the venture (Banks and/or Venders)
Obtaining Commitments: Arrangements with Fund Investors: Capital Call
when the venture fund calls upon the investors to deliver their investment funds
VC Screening Criteria: 3. Characteristics of the Entrepreneur/Team
- Ability to evaluate risk - Articulate regarding the venture - Background/experience - Capable of sustained effort - Managerial capabilities - Management commitment - References - Stake in firm
Legal Reorganization Process
- Bankruptcy petition is filed with bankruptcy court for protection under Chapter 11 while firm attempts to reorganize - Bankruptcy judge accepts or rejects the petition. If accepted, a time frame is set - Firm's management is given 120 days to submit a reorganization plan, with an additional 60 days allotted to get creditor and investor o.k. - Creditor and stockholders are grouped into classes for voting process - Accepted plan is implemented by the exchange of old creditor claims and securities for new ones
The harvesting process involves:
- Capturing value (cash value) - Reducing risk - Creating future options
VC Screening Criteria: 1. Venture Capital Firm Requirements
- Cash out potential - Equity share - Familiarity with technology, product, market - Financial provisions for investors - Geographic location - Investor control - Investor group - Rate of return - Size of investment - Stage of development
Systematic Liquidation - Advantages
- Entrepreneur maintains control throughout the harvest period - Harvesting of the venture can be spread out over several years - Time, effort, and costs of finding a buyer for the venture can be avoided
Systematic Liquidation - Disadvantages
- Liquidation proceeds are treated as ordinary income (rather than capital gains) - Difficulty for the entrepreneur to maintain focus on a dying venture - The value of the venture may decline more rapidly when competitors respond to the venture's lack of investment
Factors That Affect Growth:
- Market and Industry Factors - Management Factors - Scaling Factors
VC Screening Criteria: 4. Nature of the Proposed Industry
- Market attractiveness - Potential size - Technology - Threat resistance
Stable Growth and Maintenance
- Once your business successfully passes through rapid growth, and you can manage the financial gains, you are reached stage 4 - The firm is usually large at this point, and can remain fairly stable as long as it continues to be innovative, competitive and flexible - High-tech firms an exception to typical growth patterns
There are three ways - individually or in a combination - for resolving financial distress:
- Operations Restructuring - Asset Restructuring - Financial Restructuring
VC Screening Criteria: 5. Strategy of the Proposed Business
- Product differentiation - Proprietary product
Professional Venture Capital (VC):
- Professional VC are intermediaries between suppliers and demanders of venture equity funding. - Their time is split between maintaining relationships with inventors and providing guidance and services to their portfolio ventures. - VC tend to specialize in publicly identified niches - a. industry, b. stage and size, or c. geographic area.
Why Startup Teams Fail
- Putting structure on the organization before its time - Pretending there are sales from beta ("for free") customers - Suffocating under opportunity overload - Believing that engineers can do marketing - Licensing the technology too soon
Stages of Growth in a New Venture
- Rates and stages of growth in a new venture vary by industry and business type - But common issues arise: strategic, administrative, and managerial problems
VC Screening Criteria: 2. Characteristics of the Proposal
- Requirement for additional material - Stage of plan
Planning for Growth and Change: Expansion is a natural by-product of a successful startup:
- Some entrepreneurs shy away from growth because they fear losing control - Many businesses falter during rapid growth because of the enormous demand placed on company resources - Lesson: don't grow before your business is ready - Growth requires a successful strategy, but not the strategy followed in the past
Many entrepreneurs go solo because:
- They want total control of the startup effort - They have the resources they need to launch the venture - The startup is not expected to grow large enough to support more than one founder - The founder may simply want to avoid the difficulties associated with founding teams
Methods of Harvest
- Through a systematic distribution of assets directly to the owners - Through an outright sale of the going concern to others (i.e. family members, managers, employees, or external buyers) - Through a two-step public equity registration and sale - an initial public offering (IPO) of new shares followed by a secondary offer of existing owners' shares.
Initial Growth
- Your venture survives startup - Your business is generating revenue and your focus shifts to cash flow
What Is Investment Risk?
- chance or probability of financial loss from a venture investment - Debt, equity, and founding investors all assume investment risk - A widely accepted measure of risk is the dispersion of possible outcomes around the expected return of an investment - the standard deviation of possible investment returns
Public Financial Markets
- markets for the creation, sale and trade of liquid securities having standardized features - NYSE, NASDAQ, etc.
Private Financial Markets
- markets for the creation, sale and trading of illiquid securities having less standardized negotiated features - Individual to individual offer and sale of securities - we will be raising funding primarily in the private financial markets
Insolvent
- venture with negative book equity or net worth (balance sheet perspective) - venture with cash flows insufficient to meet current debt obligations (cash flow perspective)
Underwriting Spread:
difference between what the investment bank gets from selling securities to public investors and what they pay to the issuing firm
Screening Outcomes
1. Seek lead investor position 2. Seek a non-lead investor position 3. Refer venture to more appropriate financial market participants 4. Standard letter of rejection to the venture
VC Screening Criteria
1. Venture Capital Firm Requirements 2. Characteristics of the Proposal 3. Characteristics of the Entrepreneur/Team 4. Nature of the Proposed Industry 5. Strategy of the Proposed Business
After-tax WACC:
= (1 - tax rate) x (debt rate) x (debt-to- value) + equity rate x (1 - debt-to-value)
Franchising
A franchisee does business under your name with your product, and pays fees and royalties to you
Licensing
A licensee permits another to use your intellectual property in return for payment of a royalty
Employee Stock Ownership Plan (ESOP)
A method by which a firm is sold either in part or in total to its employees.
Sales to Strategic Buyers
A purchase in which the value of the business is based on both the firm's stand-alone characteristics and synergies that the buyer thinks can be created by the strategic fit of the firm and a potential buyer.
Sales to Financial Buyers
A purchase in which the value of the business is based on the stand-alone cash generating potential of the firm being acquired.
Vertical Integration Strategies
An entrepreneurial venture can grow by moving backward or forward within the distribution channel; vertical integration
Alliance Strategies
Another way to grow is to focus on what you do best, and let others do the rest
Horizontal Integration Strategies
Buy up competitors or start a competing business (sell the same product under another label); horizontal integration
Professional VC Investing Cycle
Determine (Next) Found Objectives and Policies --> Organize New Fund (usually partnership) --> Solicit Investments in New Fund --> Obtain Commitments for Series of Capital Calls --> Conduct Due Diligence and Actively Invest --> Arrange Harvest or Liquidation --> Distribute Cash and Securities Proceeds (as available) (its a cycle so repeat)
The Entrepreneur's Network
Professional Advisors, Consultants, Personal Advisors, Sales Support, Manufacturing Support, Governmental Agencies
Stages of Growth and Company Focus
Startup (Capital, Customers, Distribution) Early Growth (Cash Flow, Marketing) High Growth (Resources, Growth Captial, Management) Stable Growth (Innovation, Maintaining Success)
Advisory Board
The advisory board is an informal panel of experts and others who are interested in seeing your new venture succeed
Growing the Market
The choice is often between maximizing the value from the current market vs seeking new value from new markets.
Initial Public Offering (IPO):
a venture's first offering of SEC-registered securities to the public
Determining Cost Of Debt Capital: Default Risk Premium (DRP)
additional interest rate premium required to compensate the lender for the probability that a borrower will default on a loan
Investment Banking:
an intermediary assisting in the creation, sale, and distribution of financial assets
Determining Cost Of Debt Capital: Inflation premium (IP)
average expected inflation rate over the life of a risk-free loan
Financial restructuring
changing the contractual terms of the existing debt obligations and/or the composition of existing debt claims against the venture
Determining Cost Of Debt Capital: Liquidity Premium (LP)
charged when a debt instrument cannot be converted to cash quickly at its existing value
Estimating the Cost of Equity: Closely Held Corporations
corporations whose stock is not publicly traded
Determining Cost Of Debt Capital: Senior Debt
debt secured by a venture's assets
Determining Cost Of Debt Capital: Subordinated Debt
debt with an inferior claim (relative to senior debt) to venture assets
Foreclosure
legal process used by creditors (banks and vendors) to try to collect amounts owed on loans in default
Interest Rate Relationships: rd = RR + IP + DRP +LP +MP
more generally, for more complicated risky debt securities at various maturities and liquidities
Red Herring Disclaimer:
obligatory disclaimer disavowing any intent to act as an offer to sell, or solicit an offer to buy, securities
Determining Cost Of Debt Capital: Nominal Interest Rate (rd)
observed or stated interest rate
Bankrupt
occurs when a petition for bankruptcy is filed with a federal bankruptcy court
Venture Hubris:
optimism expressed in business plan projections that ignore the possibility of failure or underperformance
Management Buyout (MBO)
special type of LBO where the firm's top management continues to run the firm and has substantial equity position in the reorganized firm
Private Liquidations
when financial distress problem is viewed as permanent - the venture is estimated to be worth more dead then alive assignment - transfer of title to the venture's assets to a third-party assignee or trustee. Assignee is responsible for liquidating the ventures assets and distributing the proceeds to the creditors.
Systematic Liquidation (or Releasing the Cash Flows):
venture liquidated by distributing the venture's cash flows to the owners
Outright Sale - venture sold to others including:
venture sold to others including: - family members - managers - employees - outside (external) buyers
Private Workouts
voluntary agreement between a venture's owners and its creditors (bank and vendors) that provides for a financial restructuring of the venture's outstanding debt
Weighted Average Cost of Capital (WACC)
weighted average cost of the individual components of interest-bearing debt and common equity capital
Financial distress
when cash flow is insufficient to meet current debt obligations
