Tse sources of_capital_2014 (1)

Sources of Capital

The Smart Entrepreneur

Sources of Finance

• Internal Finance» Cash Flow from sales» Reinvested profits

• External Finance» Debt» Equity» Strategic partners» Subsidies

Copyright of Bart Clarysse and Sabrina KieferThe Smart Entrepreneur

External Sources of Finance

• Subsidies and other government measures

• Debt» Bank Loans» Leasing

• Equity» Business Angels» Venture Capital

• Strategic partners » R&D and product co-development» Joint venture


Equity investors

• Angel investors» Wealthy private investors, often experienced entrepreneurs» There are approximately 18,000 active angels in the UK and >200,000 in the

USA» British Business Angels Association http//:www.bbaa.org.uk

• Venture Capital firms» Professional equity investment that is co-invested with the entrepreneur to

finance a company in an early stage or expansion phase» Venture capital fund:

• The vehicle of pooled money through which joint investments by several investors can be made

• A VC fund’s investors may be large institutions such as pension funds or high net worth individuals – these are known as ‘Limited Partners’ or LPs


Venture Capital – particular kinds of VC funds

• Captives» Invest capital raised from a single parent organisation that is often a bank

or insurance company – different from a fund with many LPs» Are strategic investors (do not only look at return on investment, but also

consider return from other activities, such as loans that can be sold by the bank

• Public funds» Often called ‘micro-funds’» Usually small and co-invest alongside private investors

• Funds may also differ with respect to:» Size» Specialisation or diversification in terms of

Investment phase (early stage, late stage) Business Sector


Venture Capital Funds (cntnd)

corporate investors 5%

private individuals 3%

government agencies 7%

banks 22%

pension funds 19%insurance companies 9%

fund of funds 16%

academic institutions 2%

capital markets 0%not available 17%

Europe

Source: EVCA (2004)


Venture Capital (cntd)

amounts invested by stage

14.405.95210.944.574

16.920.576 18.423.246

13.916.3989.202.988

7.796.7368.533.380

6.663.403 4.183.7992.930.688 2.139.293

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2001 2002 2003

year

early phase

expansion/replacem

buyout

Europe 2,1 billion Euro

Source: EVCA (2004)Copyright of Bart Clarysse and Sabrina Kiefer


Why think about your funding strategy?

It is important to understand what kind of funding is most appropriate for your venture.

Many aspiring entrepreneurs automatically think ‘VC’, but this is the most expensive form of capital and not the first usually raised – you have to jump through a few hoops before you can raise formal VC.

Normally you will have to start with a bit of your own money, friends’ or relative’s money, or ‘soft’ public money for some early development and to remove some risk for investors.

Can you reach the point of making sales without outside equity investors? Then you might consider loan funding instead of equity.


How to seek external funding

The type of external finance you can obtain will depend upon

• Your venture’s stage of development

• Complexity of your project


Stage of Venture Development and Funding

Initial Ideas Feasibility Prototyping Commercialisation

Own cash; ‘friends, family & fools’

Grants (Govt., EC etc)

Bank Loan

Business Angels

Venture Capital

Consultancy or other earned income to live on

Real Sales!

Strategic Partners


Complexity of the project

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Personal savings Bank loan based on personal collateral

Loans from family/friends

Business angels Venture capital Government loan

Profile analysis for differences between companies with a technology complexity above and below average in regard to sources of start-up capital

Complexity above average Complexity below average

Bollingtoft et al. (2003)

Source: abetcredit.com


1. Planning your funding strategy: Key Questions

A. The ‘type’ of business you are starting affects the type of financial capital you can access

B. The rate at which your business will consume cash (the Burn Rate) and whether/when you are likely to run out of cash

C. Your attitude towards growth and to sharing ownership and control

D. What ‘stage of development’ your business is at

E. The risks involved and the returns expected by financiers

F. Your bargaining power relative to the providers of capital


A & B: Type of business and cash burn

Bank balance £

-

0

+

Technology firm•Large investment required

•Long development time to get sales cash burn

•Late cash break-even

•Huge upside (Microsoft)

• Attracts high risk/reward investor

Consulting firm•Low investment required

•Shorter lead time to sales

•Early cash break-even

•Modest upside

•Attracts lower risk/reward finance

Time


Your bargaining powerDepends on:

• How much money you need (compared to how much you already have)• How soon/urgently you need it

• How much risk your investor is taking» How protectable is your business» How much certainty of getting to market» How much customer/sales interest, contacts, ‘complementary assets’ you

already have

• How many other investors are interested in your business» And the current investment environment


Rules of Thumb

Limit your need for expensive external finance

• Bootstrapping – founders self-finance, plus family & friends (‘the 3Fs’)

» Leasing instead of buying» Customer funded R&D» Upfront payment from customers for product development» Working from home

• Limit as far as possible your need for net working capital – » Limit Expenses» Timing of cash flows (see ‘Financial Plan’ tools in IE&D Toolbox)» Least amount of inventory you can hold

• Use subsidies where possible, e.g. for» Prototyping» Feasibility studies


Selling your proposal to an investor similar to selling your product...

• The investor’s perspective:» Understand what your client/investor expects (e.g. ROI - Return on

Investment)» understand how he reasons

• The entrepreneur’s perspective:Pursue your own due diligence

» What strengths does your plan have? What weaknesses does it have? What kind of business do you want to build?

• Does it have an impact on the investor you can attract?• Does it have an impact on the investor you want to attract? (value-

adding)

• Make use of the first chance, it is unlikely that there will be a second


Government measuresCountry- and region-dependent... and change when governments change!• 7 types of measures – UK examples

» Capital Grants, Also known as ‘soft money’, e.g • See j4bgrants (link) or search on Google

» Substitution - 100% public fund---e.g.: NESTA Investments» Co-investment - government invests in a managed fund alongside a private partner,

e.g. NESTA Capital, University Challenge Seed Funds» Risk Sharing, e.g. -- Regional Venture Capital Funds - public funds that co-invest in a

company alongside a private investor, f.i. London Technology Fund

» Fiscal measures – provide tax breaks to people or companies investing through the following schemes:

• Venture Capital Trusts – a publicly quoted VC fund with tax breaks for its investors• Enterprise Investment Schemes – a tax-friendly investment in a qualifying start-up company• Corporate Venturing Scheme – tax advantages for corporations forming partnerships with

entrepreneurs• R&D Tax Credits – makes doing R&D cheaper for companies

» Incubation structures - see UKTI (link)» Loans and loan guarantees

• Enterprise Finance Guarantee Scheme (link)


Debt: The ‘five Cs’ of obtaining a bank loan

Banks look for:• Cash flow – do you have any yet? (Are you making sales,

consulting?)

• Collateral: What assets do you have to secure the loan? The bank may ask you to secure the loan against your personal assets if the company doesn’t have enough.

• Capital: What cash do already have in the company?

• Character: What is your business experience? How have you managed other loans (business and personal)?

• Conditions: your economic and industry environment


Main measures banks use to assess borrower solvency/risk

Debt ratio and coverage ratio

• Total debt ratio (%)

• Coverage of total debt

• Coverage of LT debt payable < 1yr by CF

100∗=itiesyandLiabilTotalEquit

Debt

100∗=TotalDebt

esCFaftertax

arthin theyepayable wiyrDebt

esCFaftertax

,1>=

The higher the ratio, the higher the financial risk

Can all debts be paid back with only one year’s cash flow?


Debt: Leasing your equipment

Leasing equipment instead of buying it can be a way to secure debt and spread your cash burn over time:

• A leasing company (the lessor) buys the equipment and leases it to you over the useful life of the equipment

• The equipment serves as collateral on the debt• However, you pay interest to the lessor as well as repaying principal cost

of the equipment


Equity investors: Business Angels

• Objectives : fun and return

• Often experienced entrepreneurs, so usually want hands-on involvement in a sector that they understand

• £10-£250k is a typical angel investment (some angels and angel syndicates may do more – up to £1m in a syndicate)

• Use their friends and networks to spot opportunities


Business Angels (cntd)

Expectations and Targets• Financial return: 30-35% per year• They only invest if

» there is a “match” with the entrepreneur Condition is that the entrepreneur accepts

the business angel’s involvement

• They are familiar with the sector the company is in

• Invest at an early stage, at the moment that most VCs are reluctant to invest

• They consider themselves part of the entrepreneurial team – provide mentoring and contacts

Doug Richard


Equity investors: Venture capital

Venture capital funds are answerable to their own investors• Therefore, they require a higher return than Angels, in order to make

money for themselves as fund managers and a return for the providers of capital – the Limited Partners

• They also invest higher sums than Angels, >£1m, but at a later stage

• They like to blog! More than angels do! (Not enough work to do?) (VC blog directory)

Fred Wilson – ‘a VC’ blog Biotechhttp://lifescivc.com/ blog

Mark Suster blog


VCs think in milestones…and dream of EXITS

“Nobody makes real money until the exit”

What VCs do


What VCs do with a 10-year fund

Build an investment base (raise finance from co-investors)

Build a management team

Selection and due diligence of investment projects

Follow-up on investments, monitoring

Exit investmentsCopyright of Bart Clarysse and Sabrina Kiefer


• Clean IP portfolio - Especially in early stage tech firms

• Sector - Investors back what they know (so check out their portfolio). They also learn from their mistakes.

• Financial indicators - Gross margin is a favourite – must be very high!

• Entry valuation - typically 30% less than an equivalent quoted company (a black art…)

• Exit route - can I get out? When? How much will it be worth? (also a black art..)

• Due diligence - any skeletons?

• The team - especially positive if they have worked together successfully before

What deals do VCs look for?


Belgium and NL UK France USA(n=38) (n=66) (n=32) (n=73)

general 15% 30% 25% 30%

seed and start-up 31-35% 46-55% 36-45% 46-55%

growth/expansion 21-25% 31-35% 21-25% 31-35%

buy-out 21-25% 31-35% 26-30% 26-30%

Expected yearly return

Source: Manigart et al. (2002)

What does this mean in practice?

Investment return (dependent on phase)


1387605After 6 years

895448After 5 years

577332After 4 years

372246After 3 years

240182After 2 years

155135After 1 year

100100Investment

55%35%

Required return Multiple = 6 Required return Multiple = 13,9

Investment return


Follow-up on the investment

Large differences between VC funds• Hands-on vs. Hands-off• Control vs. Value-adding

» Opening of the financial/commercial network to the portfolio company

» Negotiation of important contracts» Hire executives

• Captives and public funds are often more hands-off• Specialized funds are mostly hands-on


Exit

• IPO» Chances are limited, esp. in Europe (<5%)

• Trade sale

• Sale to another financial investor (e.g. later-stage investor)

• Management buy-out

• Bankrupcy/ Liquidation


What are your chances of getting VC funding?

250 hours….

0 20 40 60 80 100

Plans submitted

After quick scan

After few hours study

After full investigation

After price negotiations

% Remaining

3.1 minutes

2.0%

© Simon Stockley Copyright of Bart Clarysse and Sabrina KieferThe Smart Entrepreneur

If you get VC financing : what is expected of you?

Example: VC invests 2 mio Euro, in return for 40% of shares

50% return per year

Value of the investment after 5 y: 2 * 7,6 = 15,2 mio Euro

Participation = 40%

Value of the company after 5 y: 15,2 / 0,4= 38 mio Euro

P/S = 0,5

Sales (S) after 5 y: 38 / 0,5= 76 mio Euro

Market size after 5 y: 76 / 0,25 = 304 mio Euro

Market share = 25%


Differences between business angels and VCsBusiness Angel VC fund

Invest own means Invests someone else's funds

Goal: 1) fun, 2) return Goal: return

Somewhat lower return on investment Higher return on investment

Faster decision process Slower decision process

Invests in a very early stage Invests in a later stage

Less sophisticated contracts Very sophisticated contracts

Large involvement Lower involvement (fund dependent)

Longer investment horizon Shorter investment horizon

Lower legitimacy Higher legitimacy

Source: Manigart and Meuleman (2005)


Strategic Partnerships

• Co-operation at R&D level, joint venture, product co-development• Partner may take part in the start-up’s shareholder capital

» e.g.: biotech company with pharmaceutical company as shareholder» Why? Window on technology» Caveat! Restricts your exit possibilities (trade sale to competing companies is

unlikely)» A strategic partner may also see the partnership as a way to boost sales of its

own products – this may not always benefit the entrepreneurial start-up

• Corporate venturing examples in Europe:» BP AI, Bosch VC, Cisco Investments, SUN CV


Example of funding by stages: Amazon.com

Price/Share ($)Price/Share ($) Time LineTime Line Source of fundingSource of funding

Jul ‘94

Feb ‘95

Aug ‘95

Dec ‘95

May ‘96

Jun ‘96

May ‘97

Dec ‘97

0.001

0.1717

0.3333

0.3333

0.3333

2.3417

18

52.11

Founder: $10K + loan of $44K

Family: $245.5K

Business Angel: $54.4K

BA syndicate: $937K

Family: $20K

VC: $8M

IPO: $49.1M

Loan: $75MBond issue: $326M


Conclusion

• Limit your need for external finance where possible• Plan and seek the right type of finance for your current stage of

development• Understand your investor’s requirements when selling your

proposition• Use soft money (grants) where possible

‘Never buy new what can be bought second-hand

Never buy what can be rented

Never rent what can be borrowed

Never borrow what can be begged

Never beg what can be salvaged’

- Prof. Ian MacMillan, Wharton


Further reading

Clarysse, B. and Kiefer, S., 2011. The Smart Entrepreneur. London: Elliot & Thompson, Ch. 11.

Acland, S., 2001. Angels, Dragons and Vultures: How to tame your investors... and not lose your company. London: Nicholas Brealy Publishing.

Berkery, D., 2008. Raising Venture Capital for the Serious Entrepreneur. New York: McGraw Hill.


Tse sources of_capital_2014 (1)

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