Financing Entrepreneurial Ventures

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Financing Entrepreneurial Ventures

• Capital Formation

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Critical Factors

• Risk
• Reward
• Control
• Capital

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Critical Factors

• Risk can be mitigated with
• Well written business plan
• Strong management and leadership
• Reward entrepreneur should retain significant
  stake in growth of companys value and proceeds
  from ultimate sale
• Control one of the costs of capital

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Capital Issues

• How much?
• When?
• What types of securities?
• Special rights?
• Valuation
• Guaranteed returns

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How Much

• Too little ? external capital is expensive there
  are definite fixed costs and hence, economies of
  scale in financing
• Too much ? create potential credibility problem
  with investor may generate more dilution than
  necessary

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Two Viewpoints

• Entrepreneur
• Maximum capital/valuation
• Low cost of capital
• Dilution and control
• Investor
• Maximum return (lower valuation)
• Minimize risk
• Control/ input into future

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Two Viewpoints

• Common Objectives
• Growth in value of business
• Additional financing at more favorable valuations
• Mutually beneficial exit strategy

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Capital Formation Strategies

• Your money
• Money from friends, family, etc.
• SBA commercial loans
• Angels
• Wealthy individuals/families
• Bands of angels already assembled
• Bands of angels you assemble (Private Place.)

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Capital Formation Strategies

• Larger-scale commercial loans
• Venture Capital
• Early stage/seed capital
• Institutional VC (2nd/3rd round money) requires
  track record
• Big-time VC (4th/5th round pre IPO/MA)
• Initial Public Offering (IPO)

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Key Components

• Focused and realistic business plan
• Strong and balanced management team
• Wide and deep targeted market
• Some sustainable competitive advantage
• Real barriers to entry
• Sex appeal

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Financing Choices

• Debt
• Equity
• Hybrid Securities

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Debt Securities

• Simply, a promise to pay
• A long-term, fixed (contractual) obligation
• Fixed coupon (interest) payment
• Principal payment at maturity (principal also
  called par amount or face amount)
• Bond secured (also, mortgage bond)
• Debenture - unsecured

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Indenture (deed of trust)

• Contractual agreement between issuer (borrower)
  and investor
• Terms
• Amount
• Description of collateral
• Repayment arrangements
• Call provisions
• Protective covenants

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Protective Covenants

• Contractual agreements between company and
  investor
• Positive covenants things the company must do
• Maintain insurance
• Audited financial statements
• Maintain certain ratios (working capital)

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Protective Covenants

• Negative covenants things the company may not
  do
• Limitation on dividends
• Not pledge assets to other lenders
• Cannot be acquired
• Cannot dispose of significant assets w/o prior
  approval
• Cannot issue additional debt or senior debt

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Covenants

• Covenants are restrictions on what the company
  can do ? remove some control from management
• Why does the company voluntarily give up this
  control?

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Cost of Debt

• Yield to maturity determined based on value of
  bond and expected future payments
• YTM primarily a function of risk
• Risk chance that actual payments differ
  significantly from expected payments
• Default risk chance that company fails to make
  all promised payments

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Other Terms

• Call Provision gives the company the right to
  buy back (pay off) the bonds prior to maturity
• When is a company likely to call its bonds?
• Seniority bond having a prior claim
• Bond rating an assessment of the
  creditworthiness of the borrower by an outside
  rating firm (assesses repayment likelihood)

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Sources of Debt Financing

• Commercial banks usually after start-up
• Commercial finance companies
• Leasing companies for asset purchase
• Government lending programs
• SBA

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Equity Securities - Common

• Ownership claim
• Residual claim last claim on corporate cash
  flows
• No fixed repayment
• Dilution issues
• Dilution in control
• Dilution in value

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Equity Securities Preferred

• Hybrid of debt and equity
• Fixed (or adjustable) dividend
• Dividends paid prior to common dividends
• Prior claim on corporate assets in liquidation
• Voting and convertibility rights

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Cost of Equity

• What is cost if no dividends or repayment
  terms?
• Value received for shares

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Hybrid Securities

• Convertible Preferred/Debt - give the owner the
  right to convert the security into a specified
  number of common shares
• A bundle ? debt option
• Lower yield for company
• Lower cash flow up front
• Investor gets chance to participate in upside

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Sources of Equity Financing

• Private investors (angels)
• Institutional venture capital firms
• Corporate venture capital
• Microsoft, Intel, Coca-cola
• Overseas investors

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Due Diligence

• The process of obtaining information about the
  potential investment
• Purpose ? reduce risk
• Lower risk ? higher valuation, lower cost of
  capital
• Essentially the same information found in a
  prospectus for publicly issued securities

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Due Diligence Issues

• Inventory and A/R valuation
• Overdue tax liabilities
• Mgmt/comp/acctg information systems
• Related party transactions
• Reliance on 1 or few customers
• Significant immediate capital needs
• Unrecorded liabilities