LECTURE-03c Source of Capitals

8/12/2019 LECTURE-03c Source of Capitals

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Early Stage Sources of Capital 1

Early Stage Sources of

Capital


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Stages of Entrepreneurial

Development Seed $5,000 to $100,000

Startup $20,000 to $400,000

Growth $500,000 to $3,000,000

Late Growth $1,000,000 to $5,000,000

Harvest $2,000,000 to 20,000,000


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Capital Source by StageDevelopment Startup Growth Late Growth Harvest

Entrepreneur

Friends, Family

Angels

Strategic Partners

Venture Capital

Asset Lenders

SBA Loan

EDC

SBIC

Commercial Lenders

Suppliers & Customers

Private Placement

Investment BankersPrivate Equity Fund

Institutional Investors

IPO

M & A

Public Debt


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Sources of Seed Capital

Entrepreneur

Friends and family

Angels Strategic partners


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Sources of Startup Capital

Venture investment clubs

Economic development agencies

Asset-based lenders SBA loans


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Sources of Growth Capital

Commercial lenders

Suppliers & Customers

Private placements Venture capitalists

Small business investment companies


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Sources of Late GrowthCapital

Investment bankers

Private equity funds

Institutional investors


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Sources of Harvest Capital

Initial public offerings

Mergers and acquisitions

Public debt


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Entrepreneur

Personal savings

Credit cards

Home equity Retirement accounts

Life insurance


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Angels

Checkbook angels

$5,000 to $25,000

Capital A angels $25,000 to $250,000

Superangels

$250,000 to $2,000,000


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Angel Organizations

Managed Funded ActiveInvestors

AngelNetworks

PledgedFunds

Angel

Clubs

CEO

Angels


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Incubators

Advantages

Increased survival rate

Non-monetary

resources

Disadvantages

Lengthened startuptime

Low number ofgrowth firms


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Economic Development Agencies andCommunity Development Corporations

Arkansas Certified Development

Corporation Arkansas Development Finance

Authority

Southern Development Bancorporation Economic Development Corporation


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Ten Tips for Bootstrapping

1) Accelerate Startup

Plan as if time is money

Imitate competitors

2) Focus on Cash Flow

Focus on income generation Track weekly cash flow

Manage payables and receivables


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3) Be Frugal

Control growth to control cash needs

Avoid low value-added expenses

4) Rent versus buy

Use licensing versus development Use franchise versus marketing

Use leases versus purchasing


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5) Pay with Equity

Professional services

Warrants

6) Use Underused Assets of Others

Use equipment during off-peak hours Use meeting space of professionals

Use unused space of other businesses


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7) Find Non-cash Solutions

Give managers compensation time

Pay with in-kind services Pay with unused assets

8) Use Professionalism Sparingly Maintain an Internet web site

Use business centers


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9) Share Resources

Strategic partnerships

Complimentary cooperation

10) Lead by Example

Sacrifice personal assets Suggest ways to avoid cash outlays


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UALR

Entrepreneurial Financing

February 9, 2004


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Demand for Funds - Classifications of firms

Lifestyle Firmsprovide a reasonable living for their founders, account for more than 90percent of all start-ups it is unlikely that these firms will attract equity funding fromexternal parties. These business ventures typically have five year revenue projectionsunder $ 10 million.

Middle Market FirmsHave growth prospects of more than 20 percent annually and fiveyear revenue projections between $10 and $ 50 million. These firms are attractive tobusiness angel investors, but they also depend heavily on bootstrapping to fund initial

growth. These firms typically make up less than 10 percent of all start ups. High Potential FirmsTypically plan to grow into a substantial firm with fifty or more

employees within five to ten years, have five-year revenue projections in excess of $ 50million and anticipate annual growth rates in excess of 50 percent. Typically financed bybusiness angels and later by venture capitalists. These firms typically make up less than 1percent of all start-ups.

On market projections, need to verify with top down and bottom up calculations. Can notsay market is $x and all we need is x%. Investors want to see large growth opportunities

that scale quickly. Key Point- not every firm is suitable for outside equity investment based on the financial

economics of the investment. Typically, the Middle Market or High Potential firm definition would be the target market

for outside equity capital. These firms account for less than 10% of the aggregate firms.

At any point in time approximately 700,000 companies are actively trying to raise capital. Arthur Andersens 1995 national study 36 % of small, fast growing companies reported an

inability to meet their capital needs.


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Main Sources of Capitalfor Entrepreneurial Firms:

Source First Round Second Round Third Round

Founder 74 % 7 % 13 %

Family & friends 5 % 4 % 0 %

Business angels 7 % 34 % 29 %

Venture capitalists 5 % 13 % 6 %

Banks 6 % 15 % 16 %

Nonfinancial institutions 0 % 15 % 10 %

IPOs and equity markets 3 % 10 % 26 %


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Business Plan

Business plan should be clear, professional, realistic and to the point. Refine your sales pitch Prepare a 15-20 minute presentation in addition to the

plan. Really hone the presentation it is as important as the plan.

Entrepreneur develops the plan and should use plain English avoid technicaljargon.

Investors want a plan for profit not an invention. Recurring revenue modeland scalability are important factors

Business plans get your company in the door but it does not sell the deal -Business plans do not get funded people get funded.

Borrow added creditability Board of Directors and Press Releases areexamples

Set up formal communication channels and define the roles for investors

Memo vs. book Poorly developed assumptions are a main reason proposals are rejected.Other trouble spots include large salaries, back salaries, old loan obligations orbuy out of prior investors. Also investors want to see some investment by thefounders, percentages are important (% of net worth)

Sweat Equity may be an issue. The investor wants to know what can you doto create value from this point on and how far along your are in the process

helps determine valuation (risk/reward)


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January 29, 2003

Executive Summary Outline

1. Our Business2. Market Opportunity3. Value Proposition4. Proprietary or Distinguishable Position in the

Marketplace5. Competition & Market Positioning Summary6. Our Customers7. Funds Requested and Why8. Use of Funds with Expected milestones9. Exit Strategy for Providers of Capital10. Conclusion


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Bootstrapping

Bootstrapping is the most likely source of initial equity for 94 percent of newtechnology based firms. It was initially used by more than 80 percent of the fivehundred fastest growing privately held entrepreneurial firms in the UnitedStates.

Examples: Obtain Research Grants (SBIR etc.) or have customer funded R&D Commercialize University Technology Reduce/Delay Compensation Work from home Buy used equipment instead of new Borrow or lease equipment instead of buying Hire personnel for short periods instead of permanently Coordinate purchases with other firms Speed up invoicing Cease doing business with slow payers Bartering for unused equipment/people Paying people with stock or with phantom stock


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Bootstrapping

Strategies Get operational quickly copycat idea in small target market to get off the

ground fast.

Look for quick, break even, cash generating products Offer high value products or services that sustain direct personal selling

Forget about the crack employee team Keep growth in check Focus on cash (not profits, market share or anything else) Cultivate banks before the business becomes creditworthy

Try to finance and bootstrap as long as possible until the need for external

growth finance becomes evident and unavoidable

Bootstrapping does not work for companies that are growing fast. Alsobootstrapping is like zero inventory or JIT it reveals hidden problems and forcesthe company to solve them.


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Success Rates for Obtaining Investment

Venture Capital

77% of proposals rejected at the initial screening stage

20% rejected during the due diligence stage

1-3 % funded

Angels:

Typically receive 36 investment proposals per year

Interested in 8

Offers made to invest in 2, Typically find that 5% of deal flow result in adeal.


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Angel Investors

Angels are typically wealthy individuals/families willing to invest in high riskdeals offered by entrepreneurs whom they admire and with whom they wish tobe associated.

Speak with securities attorney before approaching outside investors, there are

legal issues at stake. Investors may not know about the rules but they impacthow the company raises capital over the subsequent 12 months. Typicallyequity sales to angel investors will fall under three rules of Reg D:

Rule 504 for offerings of up to $ 1 million

Rule 505 for offerings up to $ 5 million

Rule 506 for offerings over $5 million

Angel capital is not only about the money, it has to do with the resources angelsbring to fledging companies. Over 80% of angels have started a company ontheir own so they understand the process.


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Angel Investors

Angels and Venture Capital are not interchangeable.

Angels are part time investors VC are full time

Angels invest on their own behalf - VC invest on behalf of others

VC generally invest in higher amounts and have more money

Angels make investments in virtually all industry sectors.

Business angels fund thirty to forty times more ventures each yearthan venture capitalists. The National Venture Capital Associationhas suggested that angels may actually invest around $ 100 billionannually. According to the Center for Venture Research there are

400,000 angels.


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Angel Investors

Angels tend to have less risk aversion and lower expectations of return thanother types of investors. Their cost of finance is often cheaper for theentrepreneur and their funding is received more quickly than from other financesources. Angels are more flexible in their financial decisions than venturecapitalists.

Downsides include that angels are not likely to do multiple rounds, they maywant a hands on role and be unqualified and they do not have the nationalreputation or prestige when trying to get Investment Banking assistance.

Angels are more geographically dispersed. Location is important, 65% of angels

invest in deals reasonable close to where they live, within 300 500 miles.Interesting point is that 35% do not have this need they will invest as long as alead investor lives geographically close to the enterprise.


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Angel Investors

Angels tend to be men from 46-65 years of age. Age does seem to influenceinvestors to this activity. In the 56-65 year old bracket investors tend to trusttheir own judgment rather than that of brokers or intermediaries. Theseinvestors tend to have postgraduate degrees. They have a wealth of businessexperience.

Investment Size 20% indicate they invest $ 25,000 per deal 40 % indicate the invest $25,000 to $99,999 per deal 25% indicate the invest $ 100,000 $250,000 per deal 15% indicate they invest more than $250,000 per deal.

Active investors invest in 1-4 deals per year with a mean of 3 deals. Holdingperiod ran from 5-10 years. 5-15% of their portfolio is for private equity deals.Angels can also offer loan guarantees

Angels provide 84 percent of rounds under $250,000 and 58 percent between$250,000 and $500,000 while overall rounds of less than $500,000 business angelswill offer, in dollar terms, four times as much as venture capitalists.


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Investors Investment Criteria (Rough Order) forAll Investors

Criteria Angels VC Enthusiasm of Entrepreneur 1 3 Trustworthiness of the Entrepreneur 2 1 Sales potential of the product 3 5 Expertise of the Entrepreneur 4 2

Investor liked the Entrepreneur upon meeting 5 9 Growth potential of the market 6 6 Quality of product 7 10 Perceived financial rewards 8 4 Niche Market 9 13 Track Record of Entrepreneur 10 8 Investors strength filling gaps in business 14 26

Overall competitive protection 21 11 Local venture (geography) 23 27 Investors understanding of the business/industry 24 17 Potential exit routes (liquidity) 24 12 Presence of (potential) co-investors 26 25 Formal competitive protection of product (patents) 27 20


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Perfect Angel Investors

Investing expertise

Industry Experience & Contacts

Entrepreneurial Experience

Risk tolerance

Patient Money Additional Investment Deep but not to deep- pockets. Idea angel

has personal net worth of $2 million to $50 million. If an angel hasmore than that your company may fall below their radar screen. Ifthey have less you may be out of luck if you need follow on financing.

Congruent Exit Strategy

Active Participation

Cheerleader Potential


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Investment Criteria for Angel Investors

Important Investors strengths in filling gaps

Investors involvement possible

Trustworthiness of entrepreneur

Quality of product Low initial capital costs

Investor liked entrepreneur uponmeeting

Niche market

Low cost to market initially

Track record of entrepreneur

Sales potential of product

Lesser Importance Growth potential of Market

Venture is local

Ability to break even without

further funding Formal competitive protection of

products (patents)

Overall competitive position ofproduct


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Catching an Angel Investor

Step 1 - Sourcing.

Step 2 - Evaluating

Step 3 - Valuation

Step 4 - Structuring

Step 5 - Negotiating

Step 6 - Support

Step 7 - Harvesting


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Sourcing

Word of mouth. You want to comerecommended.

Determine the ideal investors foryour firm and follow a rifleapproach.

Target lead investors Check out potential investors due

diligence is a two way street

Local Angel Group. Most will nottake cold calls so you will need areferral but once you are in angelgroups offer an opportunity topresent you company to severalangels.

Professional Networks. Talk toprofessional service providers whomay know angels.

Investee firms. Firms that havereceived angel money in the pastintroduce you to their angels

Personal Networks. Explore yournetwork of friends, acquaintancesand friend of friends.

Recent US research confirms thatangels are widespread, at least 2.8percent of US households have atleast one angel in the family.

More than 50% of private equityinvestors deal flow comes fromfamily, friends, associates andcolleagues.

Snowballing. Find one businessangel can lead to them knowingothers. One caveat it is quality not

quantity. For every venture nomatter how unusual there is anangel out there willing to fund theidea.

Matchmakers. Be careful, ask forreferences and will they take thefees when you have the money.


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Evaluating - Four Main Areas

1. Peopleyou, the management team, other investors, advisors andsignificant stakeholders, anybody that has a stake in your companiessuccess.

Unique Talent or Knowledge

Contacts

Willingness to Hire Professional Management

Chemistry with Investors

Professional Advisors: Attorneys, Financial Advisors andAccountants

2. Context external factors that could impact your business includingavailable technology, customer needs, the overall economy, regulationsand competitors

3. Deal the price of the deal you propose and its structure. Price startswith valuation. Structure refers to the terms of the investment and otherfactors board seats, salary limits, etc.

4. Business OpportunityYour business model, market size, potential andactual customers and timing of your opportunity. Investors want to investin a company not a single product remember the objective is to createwealth, not make a living


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Evaluating - When making the pitch

Show Passion and Be Yourself

Focus on your team its not about just you,you do not have enough time or the skillsto do everything. Sell the Team as a Team

Show you have sales or can get them.

Make sure the deal you are proposingmakes sense from the investors point ofview. Tell the angels what is in it for them.Think through what the investors need toget out of the deal in terms of ownershipand potential returns. Do not aim tosqueeze every last nickel out of them.

From the beginning, you want investorsalways to feel as if they're making money

Discuss the exit strategy. Sell thecompany, go public et al and let themknow the time frame for such an event.

Have the necessary documents in hand,business plan, financials, corporate biosetc.

Respect the angels time. Bepunctual. Ask how much timethey have for the meeting keepyour answers short and to thepoint. If you do not know theanswer don't fake it say you

will find out and do it within acertain time frame.

Magic Words: I Dont Know.

Know What Can Bite You andSay So

Address Tough QuestionsBefore Asked/Answer the

Questions When Asked Never Oversell or Shade the

Facts

Listen and Enjoy the Process


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Search Tips

Weigh the pros and cons of angels before you being the search for anddiscussions with private investors. If angel investors are deemed appropriateform realistic expectations of roughly how much money you will need andhow much equity you are willing to surrender

Learn about angels before you go after them. Figure out the role you want

them to play for example if you need accounting help find an angel that canbring money and accounting assistance

Contrary to popular belief relatively few lawyers, doctors and otherprofessionals are currently involved as angels.

Create Excitement around the Investment - After a handful of angels haveexpressed any degree of interest, you, the entrepreneur, should move interestinto action and investment. Set a realistic deadline for the investment, thentell investors that the supply of available equity is fast dwindling.


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Valuation

Angels price the company based on its potential capital return in the futurebut realize their are non financial returns that accrue to the angel. Excitementof a start up, sense of contributing, opportunity to give something back to theentrepreneurial world, new economic opportunities for a community.

Angels value the deal less than the entrepreneurs will. Ideas are cheap its the

execution that adds value. Potential investors do not have a clue at this pointwhether you and your team will be able to execute.

Valuation methods include: sales multiples,

price-earnings ratio,

free cash flow multiple,

book value,

liquidation value, replacement value,

Comparables,

discounted cash flow


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Valuation Examples

Sales Forecast (Year 5) Under $ 50,000,000 Over $ 50,000,000

Risk High Low High Low

Founder: Inexperienced $300,000 $500,000 $600,000 $1,000,000

Experienced $600,000 $1,000,000 $1,800,000 $3,000,000

Every deal is different but some ballpark pre money valuations are as follows:

Sound idea $1 million max.

Prototype $1 million max.

Quality Management Team $ 1 -$ 2 million max.

Quality Board $ 1 million max. Product Rollout or sales $ 1 million max.

Total Potential Value $ 1 - $ 6 million max.


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Actual Returns to Investors

IRR (%) Angels (%) VC (%)

Negative 39.8 64.2

0-24 23.8 7.1

25-49 12.7 7.1

50-99 13.3 9.5

100+ 10.2 12.0

Arkansas examples:

An investor made a $20,000 investment into Wal-Mart now worth+$91 million

An investor made a $400,000 investment in 1968 into Systematics,now worth +$1 billion


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Target Multipliers

The targeted rates of return on individuals deals have to be higher sothat the portfolio can net acceptable returns. As a general rule investorstarget the following annual IRRs:

Years to Exit Development Stage Rate of Return Multiplier 6 Seed 66% 21X

5 Start-up 60% 10.5X

4 First Stage 53% 5.5X

3 Second Stage 47% 3.2X

2 Mezzanine 41% 2.0X

1 Mezzanine Pre-exit 35% 1.35X


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Structuring

First on what terms are the angels investing? Debt/equity, what type of debt/equity, willinvestors get cash before entrepreneurs, will angels have right to invest in future rounds?

Second what role will the angels play in your companies future? Will they be silentpartners or active ones?

Three fundamental ways angels invest in companies: Common Stock

Easiest & Simplest Same risk as founders Little Structural Flexibility Valuation set for future

Preferred Convertible Stock with various terms Most Common Investment Structural Flexibility

Can Manipulate IRR Upside guarantees, downside protection

Convertible note with various terms Protection of principal Interest as current return Warrants as sweetener Limited Upside


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Structuring

Everything is negotiable, time to negotiate is before the term sheet gets signed.Everybody needs to know how the relationship is going to work up front.

Downside Protective Strategies

Liquidation Preference

Straight Participating rare in early deals

Antidilution Protection

Weighted Average

Full Ratchet - Draconian

Dividends


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Structuring

Management issues Affirmative Covenants

Accounts and Reports Approval of Budgets Board of Directors Independent Public Accountants

Financial Statements Class Voting Rights

Investor Can block important corporate transactions Should disappear if preferred holds less than a certain percentage of company

Investor/Founder Issues Sweat Equity vs. Financial Investor

Vesting/Buy Back at Cost For Cause vs. No Fault Divorce Tag Along Rights Right of First Refusal/First Offer Baskets for Management Shares Non-competitive/Non Solicitation Agreements Employment/Service Agreements


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Structuring

Early In Issues Preemptive Rights All vs. Pro Rata Pay to Play

Liquidity Opportunities IPOs Registration Rights Conversion

Acquisition Liquidation Preference

Conversion Redemption

Lackluster Investments


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Negotiating

How much of the company are you going to give up? The trick is to align everyone's interest. The position you want to end

up with is its you and me against the world as opposed to its youagainst me.

During negotiations angels will tend to focus on the numbers,

specifically their initial ownership stake. They believe that will havethe greatest impact on the future return on their investment so manywill bargain hard over it.

Angels have the advantage of time, you may need to move quicklythey do not face the same time pressure. On the contrary many angelsprefer to take their time during negotiations not least of all in the hope

that you will eventually come around to their terms. Some angels will enlist a professional to negotiate others will simplyreject the deal and move on. There is no reason you can not take thesame position put your best deal forward and say politely this is a takeit or leave it position. If you are asked why say you do not want tostart your relationship off on adversarial footing.


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Support

An angels investment should be just the beginning of the interactionnot as an end point.

Feel free to solicit the angels help any way you can, find customers,follow on investors, key staff, suppliers etc.

Support should be a two way street. You should provide regularupdates to all investors. You may also want to put in key prospects orother key events and one of the investors may have a contact.


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Harvesting

Getting the investors their money back plus a return. Typically in these forms:

Walking harvest your company distributes cash directly to its investors ona regular basis.

Partial Sale your investor sell their stakes to your companys managementanother stakeholder or an outsider.

Strategic Sale A competitor acquires your company for strategic reasons,your investors receive a negotiated share of the acquisition price.

Financial Sale A buyer outside your industry acquires your company forits cash flow.

Initial Public Offering your company sells stock in the publicmarkets. Less experienced angels, overemphasize the IPO as a primary exit

route. An IPO is the exception not the rule. Negative Harvest - bankruptcy


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Venture Capital

Of the nearly one million firms that are started each year in the UnitedStates only one to two thousand actually receive venture capitalfinancing.

Venture Capitalists are rarely able to fund small start up firms seekingless than $ 5 million, regardless of the quality of the venture because oftheir specific investment criteria and high costs of due diligence,negotiating and monitoring.

Key points are have an outstanding Business Model, get Personal

Introductions and have a great Executive Summary


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January 29, 2003

Types of Venture Funds

Stage of InvestmentSeed/Start-up Mezzanine

Mid-Stage LBO

Late-Stage

LocationRegional Coastal

Nationwide

By Industry

Computer Science MedicalTelecom Biotechnology


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January 29, 2003

Venture Funds as Partnerships

Object is to create Large, Successful Companies, make OutstandingReturns on the Funds Capital - 25%+ IRR for Limited Partners andto Permit the Venture Capitalist to Share in Profits over a typical10-Year Term

Investors are Limited Partners Invest 99% of Capital No Liability Receive Capital Return First, Then 80% of Profit No Role in Decisions

Venture Capitalists are General Partners Invest 1% of Capital Some Liability Receive 20% of Profits Make All Decisions


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Initial Public Offerings

An IPO typically has to be in the $20 - $50 million range to create a market for afirm.

At the IPO stage providing financing for the firms growth is usually not themajor motivation, rather procuring exit routes and share liquidity is primary.

The SBA estimates that fewer than one in a thousand new ventures actuallyhave an IPO.

In the United States, it is estimated that only 1 percent of corporations arepublicly traded and only .25 percent are listed on an organized exchange.

Around 26-33 percent of all IPOs in the United States are venture capital fundedfirms.


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Lessons

Never split equity 50/50, and dont give away equity Friends and family financing have interesting hidden costs SBIR funds are like a gift from a wealthy uncle. It gets you to the first prototype

but does not get you to the marketplace

If you are going to get financing outside of friends and family get an externalboard.

Investment due diligence is about intgretity. It is about can I trust you? Will youmake the right decisions with my money?

Big money brings big expectations. You may not be with the company toaccomplish those expectations.

Perception is reality everybody likes a winner and wants to avoid a losingimage.

The business model is more important than the technology Do not give your family and friends a price when they invest. Give them some

predetermined premium to the valuation set by the first outside money to avoiddown rounds.

Get an external confidant to act as a sounding board, they will help you keep alevel plane


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Sources

Inc Magazine October 16, 2001

National Association of Seed & Venture Funds handouts

The Angel Investors Handbook - Gerald A. Benjamin & Joel Margulis

Angel Investing: Matching Startup Funds with Startup Companies -- AGuide for Entrepreneurs, Individual Investors, and Venture Capitalists- Robert J. Robinson & Mark Van Osnabrugge

Documents

LECTURE-03c Source of Capitals