Keys to Financing the New Venture Alec Johnson, Ph.D. University of St. Thomas

Keys to Financing the New Venture

Alec Johnson, Ph.D.University of St. Thomas

The Problem

“Small business management is cash flow management.” Dr. Robert Pricer, Weinert Applied Ventures Program, Unviersity of Wisconsin

“Cash is King.” Dave Stassen, Partner, St. Paul Venture Capital

“You’re not an entrepreneur until you’ve written payroll checks on Friday and spent the weekend collecting the cash to cover them.” Keith Streckenbach, founder and CEO of PharmacyOneSouce.com

Entrepreneurial Finance vs. Corporate Finance

Differences from Corporate Finance– Diversification and Value– Involvement of Investors– Harvesting

The Problem - Objectives

Minimize Cost Maximize Return

Maintain Control

Maximize Ownership

Minimize Involvement

Minimize Risk

Entrepreneur

Investor

The Problem - Management

What is the Ultimate Task of an Entrepreneur?

• Job #1 is Risk Management• Job #1 is Risk Management

• Largest risk is Financial and question becomes “How?”

• Largest risk is Financial and question becomes “How?”

The Problem - Structure

Type, i.e. Do I use debt, equity or some combination.Timing, i.e. When do I need it?Amount, i.e. How much do I need?

Type – Two General Classes

Debt– Represents a fixed cost– Represents more risk– Cheapest type of outside

financing

Equity– No interest payment– No obligation to repay– Most Expensive type of

financing

Sources of Debt Financing

Friends and FamilyBanksLeasingFactoring

Bank Financing

Commercial banks are the largest source of external capital for growing firms.Problems:– Lack of collateral– Lack of earnings history

Leasing

Often used technique to acquiring assets without having to purchase them.Two types of Leases:– Operating Lease– Capital Lease

Factoring

Factors buy company’s accounts receivables at a discount.Recall R&R case.Gets cash to company quickly, but must have cost of factor available in profit margin.

Equity

When to use equity?– Every company has some form of equity.– Founders raise equity when:

• there is no collateral to secure debt• insufficient cash flow to secure debt• required growth capital more than banks can provide.

Types of Equity Instruments

Typically used in small business placements:– Common Stock– Preferred Stock

Types of Equity Instruments

Common Stock Characteristics:– Most common form of issuance– Last in liquidation = ?– Represents Entire ownership of firm.

Types of Equity Instruments

Preferred Stock Characteristics:– Pays dividends– Preference in liquidation

Types of Equity Instruments

Preferred Stock Characteristics:– Looks a lot like Debt!– Used by Venture Capitalists to gain position in

liquidity event while minimizing risk.

Types of Equity Investors

Angel InvestorsVenture Capitalists

Types of Equity Investors: Angels

Typical Angel Investor– Private individual (not an institutional fund)– Age: 47 –54 years– Gender: Male– Net Worth: $1,000,000 +

Types of Equity Investors: Angels

Typical Angel Investor– Education: Bachelors or greater– Average Investment: $59,000– Preferred Stage: Start-up (56%) and infant or

young (24%)

Types of Equity Investors: Angels

Typical Angel Investor– Required Rate of Return: 15% - 45%– Length of Investment 3 – 10 years– “Patient Money”

Types of Equity Investors: Venture Capital

Typical Venture Capital Firms– Institutional Firm– Raises money from various sources, including Angels– Creates “pool” of capital, a fund.– Develops portfolio of firms under management

Types of Equity Investors: Venture Capital

Typical Venture Capital Firms– Average Investment: $1 M to $50 M per investment.– Industries: High Growth, early or later stages– Services Provided: None to direct management decision making and

board control.– Required Rate of Return: 10X in 3-5 years.– Typically invest using Preferred Stock

Venture Capital Investments, Q2 2001

2.2% of Venture Capital invested in Midwest!

0

5

10

15

20

25

30

Communications

and Networking

Consumer and

Business

Services

Biopharm Semiconductors Med Sftwr Retailers Consumer &

Bus.

DollarsShare

Timing – Sources of New Venture Financing*

Development Start-Up Early Growth

Rapid Growth Exit

Entrepreneur/Friends/Family

Angels/Partner

Banks/Lessors

Venture Capital

IPO

*Adapted from: Smith and Smith, Entrepreneurial Finance, 2000

Timing - Cash Needs

Goal is to manage risk to business and to investor.Minimize risk by staging investmentsEstablish stages by developing solid business plan and financial projections!

Case Study – Ascend Medical

Facts:• Development stage Medical Device company.• Prototype of catheter for stroke victims nearly complete.• Market need unclear.• FDA process is three years and $30M in expense• No guarantee of approval.

Case Study – Ascend Medical

Analysis – Type?• Debt is not an option.• Angels to get the product through prototype development,

further market study, conduct focus groups with doctors. $500,000.

• Venture Capital to take it through FDA process and initial market launch. $45M

Case Study – Sporto

Facts:• Start up phase winter apparel company• One season’s sales under it belt• Moderate growth plans• Required funds: $1.5 M• Needs immediate funds of $100,000 to expand sales

organization and $1.4 M to expand product line and related marketing expenses over the next 18-24 months

Case Study – Sporto

Analysis – Type?• Venture Capital not an option – growth too slow• All debt not an option – unless financials can demonstrate

adequate cash flow and plenty of collateral available.• Private equity with debt mix is viable option• Factoring after sales grow, leasing office equipment• Alternative?

Case Study – Sporto

Analysis – Timing?• Could split rounds up, reduce overall cost of capital.• Rounds are close enough that it might make sense to

raise all at one time.• Unless founder gets lucky? Example

The Big Picture – Business Plan

Competitor Analysis

Environmental Trends

Customer Analysis

Business Plan

Functional Plans

Pro formas

Financing

Evaluation-CMOPs

Business Plans

What is a business plan?– Something you produce because the bank expects

it?– Something you produce because every says you

should?– ?

Business Plans – Make Your Argument

Argument contains some consistent themes– What is the product or service?– Who is MOST likely to buy it?– How much are they willing to pay for it?– How many of “THEM” are there?

Business Plans – Make Your Argument

Argument contains some consistent themes– Who is MOST likely to buy it?– Where and How will they purchase the product?– How will I let them know about it?– Does my team have the ability to execute the plan?

“Everything should be made as simple as possible, but not more so.”

Albert Einstein

Business Plan-The Purpose

A Sales Document to Raise CapitalA Road Map to Developing a Successful Organization-Do we have a product the market wants and do we have an organization that can see it to market?

The Plan makes an argument for why the business will be successful!!!!!

Business Plan Outline

Executive SummaryCompany HistoryMajor Products/Services

Marketplace

Competition

Marketing Plan

Operations-ManufacturingManagement Team

RisksFinancial Analysis

Company Description

What business are you in?What are your:– products or services?– customers?– applications? (Different uses and needs satisfied

What is your distinctive competence?What is your competitive advantage?What is your Mission Statement

Sustainable Competitive AdvantageSustainable Competitive Advantage

Versus Distinctive CompetenceVersus Distinctive Competence

Ask the question “What do we have that can’t be replicated by our competitors?” vs. “What are we good at?”

Mission Statement

What do we do?How do we do it?Who do we do it for?

Example: Brew – On - Premise

Market Analysis & Marketing

Industry description and outlookTarget markets (segments)CompetitionReaction from prospective customersMarketing activities (strategy/pricing)Selling activitiesThe Key is your Feasibility Study

Example 1: Brew on Premise

Total Population (% age 24-55)

Median Income Median Rent (upper quartile)

Boulder County,

Colorado225,339 (52%) $35,322 $449 ($585)

Dane County,

Wisconsin367,085 (54%) $32,703 $423 ($527)

Example 1 - Brew on Premise

•Counties are comparable

•15 batches per day in Boulder

•Ratio of target population 1.6:1

•Expected revenues for Badgerland to reach 24 batches per day after 2 years of operation.

Example 2 – Ascend Medical

Different approach to argumentFocus isn’t one likely demographicFocus is on treatable number of cases

Example 2 – Ascend Medical

Process: 1. Population growth through 2010 (Source: US

Census)2. “Target” population not important. All medical

research data based on incidence in US population.

3. Medical data implies number of treatable cases by type of stroke.

Example 2 – Ascend Medical

Process: 1. Once number of treatable cases established by

type of stroke, can then establish type of treatments received.

2. Those requiring clot removal (vs. stenting, etc.) are established as likely candidates for this procedure.

3. 356,000 treatable cases today, growing to 560,000 in 2010.

Management and Ownership

Key management positionsBackground of personnelBoard of DirectorsOwnershipStarting a business is about building a successful organization and working in a “team.”Does your team cover all the necessary roles or have you developed a plan to cover areas that are weak?

Management

FranchiseSoftware, Medical Device, etc.

Low HighModerate

Granite Gear

Level of Sophistication

Product Development

Level of Complexity

FranchiseSoftware, Medical Device, etc.

none highmoderate

Granite Gear

Time To Market

FranchiseSoftware, Medical Device, etc.

short highmoderate

Granite Gear

Time to Profitability

FranchiseSoftware, Medical Device, etc.

Short < 6 months

High >24 months

Moderate 9 to 18 months

Granite Gear

Market Risk

FranchiseSoftware, Medical Device, etc.

High LowModerate

Granite Gear

Product Acceptance

Capitalization

FranchiseSoftware, Medical Device, etc.

Low < $50,000 High > $2MModerate $500K to $2M

Granite Gear

Risks

Competitive RisksTechnological RisksOrganizational RisksMain Point: Identify them and develop a plan to deal with them if and when they arise.

Funds Required and Their Uses

How much money do you require now?How much will you require over the next five years?How will the funds be used?

Funds Required and Their Uses

Debt/Equity mixWhat terms do you ask? (Let the commercial money market help you select winners)Do you plan to “harvest?” Be explicit about the deal you offer…

Financial Data

Historical financial statements and projections for the next five yearsKey assumptions

Appendices

ResumesPictures of productsSales literatureSupporting published market studies or trade journal articlesPatents

The Big Picture

Competitor Analysis

Environmental Trends

Customer Analysis

Business Plan

Functional Plans

Proformas

Financing

Evaluation-CMOPs