Lecture Patterns of entrepreneurship management (5th edition) - Chapter 8: Funding the venture – Part 2

Chapter 8 - Funding the venture, part 2: Equity and debt financing for high growth. The contents of this chapter include all of the following: Important terms used in equity investment, the current status of the venture capital sector, the venture capital process, the private placement process, bank loans, valuing an early stage company, general guidelines.

Funding the Venture – Part 2 Ch 8, Pt. 2 Equity and Debt Financing for High Growth Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations Patterns of Entrepreneurship Management th  Edition, Chapter 8, Part 2 Copyright 2015 Jack M. Kaplan & Anthony C. Warren Presentation Outline   Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt • • • • • • • Important terms used in equity investment The current status of the venture capital sector The venture capital process The private placement process Bank loans Valuing an early stage company General guidelines  Valuations Copyright 2015 Jack M. Kaplan & Anthony C. Warren Key Terms For Equity Investments  ­ 1 • Equity Investment occurs when an entrepreneur sells Ch 8, Pt. 2 part ownership in the company to raise funds Fundamentals • In Private Equity, shares are illiquid and cannot easily  be sold until a liquidity event, also known as an Exit,  VC Status occurs VC Process • In doing so the entrepreneur suffers Dilution as they now  PPM’s own less of the company Crowd­Funding• The value of the company prior to the investment is  termed Pre­money, and after, Post­money Bank Debt • Investors usually own Preferred Stock, which carries  certain Preferences over the founders(s) Valuations • Convertible Loans are a form on investment that starts Copyright 2015 Jack M. Kaplan & Anthony C. Warren out as a loan but can be converted later into ownership Key Terms For Equity Investments  ­ 2 Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations • • • • Investments occur in Rounds termed seed, A, B, C etc If value decreases between rounds it is a Down Round A Capit(alization) Table lists the % ownership Investors expect to earn a high Internal Rate of Return,   IRR of at least 30% for taking a high risk • Investors may also receive Stock Options or Warrants  permitting them to buy more ownership at a later date at a  pre­determined (low) value • Private Stock rarely pays a Dividend, or if one exits it is  usually accrued until a liquidity event • A Stock Option Pool  is part of the future compensation  for key employees. It is listed in the Cap Table Copyright 2015 Jack M. Kaplan & Anthony C. Warren Key Terms For Equity Investments  ­ 3 • Investors may also insist certain Covenants: Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations • • • • • A board seat Control of certain management decisions Right to invest in later rounds Protection against dilution if milestones are not reached Right to force an exit after a certain time • Bridge Financing helps the company get to the next  financing round. This can be very dilutive • Term Sheet is a non­binding agreement to invest • Due Diligence, a detailed investigation of a company  performed after a term sheet is agreed.  • Lead Investors source deals, undertake due diligence,  negotiate terms, take board seats.  Copyright 2015 Jack M. Kaplan & Anthony C. Warren Pre­and Post­Money  Cap Table Example Ch 8, Pt. 2 Fundamentals Pre-Money Cap Table Ownershi p Name Total= VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations Shares 1,000,0 00 45% Founder A 450,000 45% Founder B 450,000 Option Pool 100,000 10% 100.00% Post-Money Cap Table Value $50,00 $22,50 $22,50 $5,000 Share Price Owner ship $0.05 33.33% 33.33% 6.67% 26.67% 100.00 % Name Total= Founder A Founder B Option Pool Investor Shares 1,500,0 00 500,00 500,00 100,00 400,00 Value $1,500,0 00 $500,00 $500,00 $100,00 $400,00 In this example, the two founders sell part of the company for an investment of $400,000 Their ownership is diluted, and they have also allocated part of the ownership of the company in the form of a Stock Option Plan for future employees Copyright 2015 Jack M. Kaplan & Anthony C. Warren Share Price $1.00 Sources of Rounds of  Equity Finance Round Ch 8, Pt. 2 Status Pre-seed* Barely an idea, rough business plan Expected IRR Friends/family, bootstrapping, grants, and 1–40% microequity funds Fundamentals VC Status Likely Sources of Funds Seed* Prototype or proof of principle, no sales Angels, grants, possibly a local VC firm 20–40% A Round* Development nearly complete, first trials Super-Angels, early-stage VC VC Process 30%+ with customers PPM’s B Round Customers, first growth phase C/D Sufficient to get to cash flow neutrality or Late-stage VCs in syndicate Bank Debt Rounds exit Valuations Mezzanine Prepare for sale or IPO, acquisitions Crowd­Funding VC or other institutional sources of funds 30%+ Large private equity funds 20%+ 15–20% Note: crowd-funding can be considered at these stages* – see Chapter Copyright 2015 Jack M. Kaplan & Anthony C. Warren Discounted Convertible Debt Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations  This form of investment is often used in early rounds as  it avoids the difficult issue of valuation in a start­up  Investors lend money to the company (called a  debenture)    The money earns interest (referred to as coupon)  between 7­12%  Interest is not paid but accrued  When a defined level of equity is raised later, the first  investors can choose to convert their total debt at a  discount of between 20­24% to the new money  The discount may be time dependent Copyright 2015 Jack Kaplan and Anthony C. Warren IRR of VC Funds by Vintage Year Source: Cambridge Associates LLC, 2012 Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations The dot.com bubble in the late 90’s fundamentally changed the Venture Capital landscape At its peek VC firms raised a lot of money, but have been unable to achieve any reasonable returns in the last decade In order to invest their large amounts of cash the focus has moved to later stage companies making it very hard for entrepreneurs to get early stage venture financing Copyright 2015 Jack M. Kaplan & Anthony C. Warren Venture Capital Raised by Vintage Year Ch 8, Pt. 2 Fundamentals Source: NVCA, 2011 VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations This chart shows the impact of the dot.com bubble on the ability of VC’s to raise large funds The poor returns over the last decade have reduced the amount of new money flowing to the fund managers until recently Copyright 2015 Jack M. Kaplan & Anthony C. Warren How the Money Flows IN Ch 8, Pt. 2 Annual Management Fee = 2- 3% Fundamentals VC Status VC Process PPM’s Crowd­Funding Called Investment From Limited Partners Individual CoInvestments Bank Debt Valuations Copyright 2015 Jack M. Kaplan & Anthony C. Warren How the Money Flows OUT Ch 8, Pt. 2 Fundamentals Money Back “off the top” + 80% of the Remaining VC Status 20% “Carry” VC Process PPM’s Crowd­Funding Bank Debt Valuations Acquirer or IPO Copyright 2015 Jack M. Kaplan & Anthony C. Warren Using a Private Placement  Memorandum (PPM) Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding •An alternative to seeking venture capital, is to offer shares in your company to one or more private investors using a PPM •There are a number of federal and state restrictions that must be met and you will need a securities lawyer to prepare the documents and make sure all the regulations are followed •You should only offer shares to “accredited investors” who must meet certain requirements regarding personal net-worth and income history They must certify in writing that they are able to lose all their investment •The PPM must list all the risk factors in the investment Bank Debt Valuations •There are private bankers that have networks of private investors that they advise You will need an introduction and you should check on references They take a fee for raising the agreed finance Copyright 2015 Jack M. Kaplan & Anthony C. Warren Examples of PPM Regulation  Classes Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations Rule 504 • Up to $1,000,000 • 12  month completion period • No restrictions on the number of  investors Rule 505 • Up to $5 million • 12 month completion period • No more than 35 non accredited investors and unlimited  number of accredited investors Rule 506 • Unlimited amount of raising funds • No more than 35 unaccredited but sophisticated purchasers.and  to unlimited number of accredited investors • must be able to evaluate merit and risks Copyright 2015 Jack M. Kaplan & Anthony C. Warren Crowd Funding  Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations • In March, 2012, the so­called JOBS ACT  was signed into law • As part of the bill, the requirements for  raising private equity from individuals were  relaxed in  to assist  Small Business Owners  and entrepreneurs to raise early stage money  and easier to go public more quickly • For the first time ever, members of the public  may invest in private startup companies  using the Internet and social media sites • This topic is covered in detail under Ch. 5 Copyright 2015 Jack M Kaplan & Anthony C Warren 26 Potential Risks  Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations • Having a large “crowd” of unknown  investors may bring management head­ aches when it is time to have a  shareholders’ vote on key issues.  • The chances of a frivolous shareholders’  law suit will increase • Intellectual Property may be  compromised Copyright 2015 Jack M Kaplan & Anthony C Warren 27    Potential Risks  Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations • In addition, if your company is highly  successful and needs more capital,  institutional venture capitalists are  unlikely to fund a company with a  “crowd” of shareholders for these reasons • One way to avoid this problem is to have  individuals invest via a “voting trust”  whereby an independent trustee takes  actions on behalf of the shareholders Copyright 2015 Jack M Kaplan & Anthony C Warren 28 Bank Loans Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt  As the company grows it may be possible to  acquire some debt financing from a  commercial bank  Usually personal collateral will be required  until the company has hard assets   As with VC’s, get recommendations to banks  that work with small companies  Develop a relationship with a banker BEFORE  you need a loan Valuations Copyright 2015 Jack M. Kaplan & Anthony C. Warren Preparing a loan proposal Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Once a relationship has been developed you will require a formal application including: Summary Page Management team Profiles Business Description Financial Projections Purpose of Loan and how spent Amount required Repayment Plan Valuations Copyright 2015 Jack M. Kaplan & Anthony C. Warren How to Apply for a Bank Loan Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations  Prepare a loan Proposal  Fulfill the four “C”s  of a loan request Character ( of the applicant) Cash Flow ( of the company) Collateral ( what happens when things go  wrong Contribution ( how much are YOU putting  up?) Banks usually require your house as  security for the loan Copyright 2015 Jack M. Kaplan & Anthony C. Warren Valuation Techniques  For Early Stage Ventures Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s •At the early stages of a venture there are no historical financial  performances on which to base a value using conventional  accounting methods •However, unless the founders decide to use convertible debt in the  initial 1­2 investment rounds, a value must be agreed with an equity  investor to determine what % of the company must be sold •These three methods can be used: − Discounted cash flow of predicted earnings Crowd­Funding − The venture capital model based on future liquidity event − Milestone methods Bank Debt Valuations • All three methods should be used to provide guidance BUT in the  end the value will depend on the current investment market and  negotiations on the total transaction terms Copyright 2015 Jack M. Kaplan & Anthony C. Warren Early Stage Valuation Discounted Cash Flow (DCF) • The business plan should have financial pro formas  for 5­7 years Ch 8, Pt. 2 Fundamentals •For the first 1­2 years the cash flow will be negative but thereafter it  should be positive and growing VC Status •The sum of these cash flows are discounted back to the present  using a chosen internal rate of return or discount rate VC Process •The earlier the stage of the company, the higher the risk is for an  investor, and hence the discount rate will be higher too PPM’s •The minimum discount rate is 30% for an early stage company Crowd­Funding •  In addition investors are likely to reduce your estimated cash flows  Bank Debt Valuations recognizing that companies rarely meet their financial targets in the  early years. A factor of 2X reduction is typical • The modified current value of future cash flows is the assumed  current value of the company Copyright 2015 Jack M. Kaplan & Anthony C. Warren Early Stage Valuation The Venture Capital Model • This is often used by VC’s to determine their investment decision Ch 8, Pt. 2 •Investors can only receive a return on their investment when there is a  LIQUIDITY event – the company is sold to another or there is an IPO Fundamentals • Therefore the investor wishes to know what the company COULD be  sold for, if it meets its goals, and WHEN VC Status VC Process • Comparisons are sought for transactions where similar ventures have  been sold ( COMPS) •These values may be based on different metrics ­  P/E Ratios,  Revenues, Growth, Gross Margins and Strategic Importance Crowd­Funding • These SALE values are discounted back to the present using a 30%  minimum discount rate, reduced for the risk level to get today’s value PPM’s Bank Debt Valuations • If the entrepreneur can argue that the sale could be strategic to a few  competitors, the value is likely to be enhanced Copyright 2015 Jack M. Kaplan & Anthony C. Warren Early Stage Valuation Milestone Methods Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s • The lack of  financial history, and uncertainty of meeting the business  plan, has investors seeking other methods of determining value •The attainment of key milestones is often used •One simple model is the Berkus model:  If Exists Add to Value Sound Idea (Basic Value)  Up to $500K Prototype, reducing technology risk $500K ­ $1M Good management, reducing execution risk $500K ­ $2M Quality Board, reducing governance risk Up to  $1M Sales, (reducing production risk Up to $1M Crowd­Funding Strategic Relationships, reducing marketing risks $500K ­ $1M Bank Debt Valuations •Another is the 25 question Cayenne Valuation Model  Copyright 2015 Jack M. Kaplan & Anthony C. Warren Example of Milestone Valuations Ultrafast Milestones and Value Creation Ch 8, Pt. 2 Fundamentals VC Status VC Process PPM’s Crowd­Funding Bank Debt Valuations Copyright 2015 Jack M. Kaplan & Anthony C. Warren ... example, the two founders sell part of the company for an investment of $400,000 Their ownership is diluted, and they have also allocated part of the ownership of the company in the form of a Stock... By Industry Sector By Location of the Venture By Stage of Development of the Venture By Stage of Their Fund By Size of Funding Required By Their Perceived Ability to Add Value   Copyright 20 15 Jack M. Kaplan & Anthony C. Warren... acquisitions Crowd Funding VC or other institutional sources of funds 30%+ Large private equity funds 20 %+ 1 5 2 0% Note: crowd -funding can be considered at these stages* – see Chapter Copyright 20 15 Jack M. Kaplan & Anthony C. Warren