Copyright 2013 Jack M. Kaplan & Anthony C. Warren Equity and Debt Financing for High Growth Patterns...

Copyright 2013 Jack M. Kaplan & Anthony C. Warren

Equity and Debt Financing for High Growth

Patterns of Entrepreneurship Management4th Edition,Chapter 10

Funding the Venture -2

Chapter 10

Fundamentals

Valuations

VC Status

VC Process

Bank Debt

PPM’s

Crowd-Funding


Presentation Outline

• 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

Chapter 10

Fundamentals

Valuations

VC Status

VC Process

Bank Debt

PPM’s

Crowd-Funding


Key Terms For Equity Investments - 1

• Equity Investment occurs when an entrepreneur sells

part ownership in the company to raise funds

• In Private Equity, shares are illiquid and cannot easily be sold until a liquidity event, also known as an Exit, occurs

• In doing so the entrepreneur suffers Dilution as they now own less of the company

• The value of the company prior to the investment is termed Pre-money, and after, Post-money

• Investors usually own Preferred Stock, which carries certain Preferences over the founders(s)

• Convertible Loans are a form on investment that starts

out as a loan but can be converted later into ownership

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• 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 pre-determined (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.

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• Investors may also insist certain Covenants:• 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 non-binding 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.

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Pre-Money Cap Table Post-Money Cap Table

Ownership Name Shares ValueShare Price

Ownership Name Shares Value

Share Price

Total=1,000,00

0 $50,000 $0.05 Total=1,500,0

00$1,500,0

00 $1.00

45% Founder A 450,000 $22,500 33.33% Founder A 500,000 $500,000

45% Founder B 450,000 $22,500 33.33% Founder B 500,000 $500,000

10%Option

Pool 100,000 $5,000 6.67%Option

Pool 100,000 $100,000

26.67% Investor 400,000 $400,000

100.00%100.00

%

Pre-and Post-Money Cap Table Example

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.

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Round Status Likely Sources of Funds Expected IRR

Pre-seed Barely an idea, rough business plan Friends/family, bootstrapping, grants,

and microequity funds

1–40%

Seed Prototype or proof of principle, no sales Angels, grants, possibly a local VC firm 20–40%

A Round Development nearly complete, first trials

with customers

Super-Angels, early-stage VC 30%+

B Round Customers, first growth phase VC or other institutional sources of funds 30%+

C/D

Rounds

Sufficient to get to cash flow neutrality

or exit

Late-stage VCs in syndicate 20%+

Mezzanine Prepare for sale or IPO, acquisitions Large private equity funds 15–20%

Sources of Rounds of Equity Finance

Chapter 10

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Copyright 2013 Jack Kaplan and Anthony C. Warren

This form of investment is often used in early rounds as it avoids the difficult issue of valuation in a start-up

Investors lend money to the company (called a debenture)

The money earns interest (referred to as coupon) between 7-12%.

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 20-24% to the new money

The discount may be time dependent

Discounted Convertible Debt

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Source: Cambridge Associates LLC, 2012

IRR of VC Funds by Vintage Year

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.

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Venture Capital Raised by Vintage Year

Source: NVCA, 2011

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.

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VC Performance 1990-2008


Here are these two sets of data superimposed to show the high influx of funds while returns plummeted.

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The IPO Dearth Years

Concurrently, poor economic conditions have suppressed the Initial Public Offering market, with exits moving to corporate purchases. This shift makes building a “virtual” or “essential” company an attractive strategy.

Source, NVCAChapter

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Summarizing Trends in VC’s


• Funds have got larger….• Money must be “put to work” but….• New business models can be more capital efficient….• Resulting partly from the impact of the Internet• So Entrepreneurs are using other sources of funds• Bootstrapping is de rigeur in current environment

• New Models have emerged to fill the gap:• Early Buy-in by VC-funds to “capture” deal - little due diligence • Micro-equity funds such as YCombinator and DreamIt Ventures combining networking and seed funding • “Crowd-Funding*” - Internet sourcing of loans or equity• Virtual companies – use resources from anywhere only when required

* See Kevin Lawton’s site: http://www.trendcaller.com/

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Venture Capital is Focused

VC Firms Specialize: • 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

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High returns (IRR’s) of 30% or more Or alternatively 10 times money invested High growth companies Deals requiring over $2 million for the

initial round and possibly > $10 million overall in multiple rounds

Company has gained its first customers An exit within 3-5 years

Venture Capitalists Seek:

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What VC’s Expect

• For a typical start-up - Venture Capital Fund will invest 2-3 million for 40% preferred equity ownership position.

• This gives VC’s a liquidation preference over common shares until the 2-3 million is returned.

• If Venture fails, they have first claim to assets including technology.

• Also blocking rights over key decisions including sale of the company or IPO.

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• Anti-dilution clauses or “Ratchets” - This protects against equity dilution of additional rounds of financing in “down-rounds”.

• This preferential treatment comes at the expense of all common shareholders.

• If company does well, VC enjoys upside provision by having right to put additional money at a set price using warrants or options.

• Limiting risk by co-investing with other firms known as “syndicating”.

VC’s also ask for:

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There are client or customer references The opportunity is considered a “hot” area The venture delivers scalable technology and markets The team is diligent and goal oriented The entrepreneur is skilled in finance, capital and deal

structures The entrepreneur will accept advice The entrepreneur will not resist replacement if they are

not capable of managing growth Realistic expectations are incorporated into goals of

the company

Profile of the Ideal Entrepreneur from a VC

Perspective

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Optimistic Investment Timeline

WEEK TASK

0 Entrepreneur identifies VC’s with appropriate match to needs

2-4 Entrepreneur gains personal introduction to a partner(s)

2-6 Entrepreneur has first telephone call, sends executive summary

4-6 Additional telephone calls, and exchange of business plan

6-8 Invitation to first presentation

8-12 Invitation to a full partners’ meeting presentation and discussions

10-16 Negotiation of Term Sheet, Signing of a Non-Disclosure Agreement

12-20 Due Diligence

16-24 Re-negotiation of Term Sheet, preparation of full legal documents

18-30 Closing and deposit of first tranche of investment funds

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The Structure of VC’s


VC General Partnership(s)

Limited Partners

General Partners

VC II

Syndicate

Portfolio Companies

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How the Money Flows IN


Annual Management Fee = 2- 3%

Called Investment

From Limited Partners

Individual Co-Investments

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How the Money Flows OUT


Acquirer or IPO

Money Back “off the top” + 80% of the Remaining

20% “Carry”

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Using a Private Placement Memorandum (PPM)

• 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

• 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.

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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.

Examples of PPM Regulation Classes

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Crowd Funding

• In March, 2012, the so-called 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 .

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Crowd-Funding

• This is called crowd funding. • Entrepreneurs can raise up to $1 million

online each year from individual investors with minimal financial disclosure.

• Investors with annual incomes of less than $100,000 are limited to $2,000, while those who make over $100,000 are limited to $10,000.

• The bill requires crowd funding sites to provide educational materials for investors’ risks.

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Crowd-Funding

• The legislation also does away with the Regulation 500-shareholder rule, which put a cap on the amount of shareholders a company was allowed before having to register with the SEC

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Potential Risks

• 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.

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Potential Risks

• 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.

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Bank Loans

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

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Once a relationship has been developed you will require a formal application including:

Summary PageManagement team ProfilesBusiness DescriptionFinancial ProjectionsPurpose of Loan and how spentAmount requiredRepayment Plan

Preparing a loan proposal

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How to Apply for a Bank Loan

Prepare a loan ProposalFulfill the four “C”s of a loan request

Character (of the applicant)Cash Flow (of the company)Collateral (what happens when things go

wrongContribution (how much are YOU putting up?)Banks usually require your house as security

for the loan

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• 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 1-2 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

− The venture capital model based on future liquidity event

− Milestone methods

• 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.

Valuation Techniques For Early Stage Ventures

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• The business plan should have financial pro formas for 5-7 years

•For the first 1-2 years the cash flow will be negative but thereafter it should be positive and growing

•The sum of these cash flows are discounted back to the present using a chosen internal rate of return or discount rate

•The earlier the stage of the company, the higher the risk is for an investor, and hence the discount rate will be higher too.

•The minimum discount rate is 30% for an early stage company

• In addition investors are likely to reduce your estimated cash flows 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.

Early Stage ValuationDiscounted Cash Flow

(DCF)

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• This is often used by VC’s to determine their investment decision.

• 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

• Therefore the investor wishes to know what the company COULD be sold for, if it meets its goals, and WHEN.

• 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.

• 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.

• If the entrepreneur can argue that the sale could be strategic to a few competitors, the value is likely to be enhanced

Early Stage ValuationThe Venture Capital Model

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• 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:

Early Stage ValuationMilestone Methods

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

Strategic Relationships, reducing marketing risks $500K - $1M

Quality Board, reducing governance risk Up to $1M

Sales, (reducing production risk Up to $1M

•Another is the 25 question Cayenne Valuation Model

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Ultrafast Milestones and Value Creation

Example of Milestone Valuations

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Copyright 2013 Jack M. Kaplan & Anthony C. Warren Equity and Debt Financing for High Growth Patterns...

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Transcript of Copyright 2013 Jack M. Kaplan & Anthony C. Warren Equity and Debt Financing for High Growth Patterns...