Capital Source by Stage Public Debt M & A IPO Institutional Investors Private Equity Fund Investment Bankers Private Placement Suppliers & Customers Commercial Lenders SBIC EDC SBA Loan Asset Lenders Venture Capital Strategic Partners Angels Friends, Family Entrepreneur Harvest Late Growth Growth Startup Development
Economic Development Agencies and Community Development Corporations
Arkansas Certified Development Corporation
Arkansas Development Finance Authority
Southern Development Bancorporation
Economic Development Corporation
Ten Tips for Bootstrapping
1) Accelerate Startup
Plan as if time is money
2) Focus on Cash Flow
Focus on income generation
Track weekly cash flow
Manage payables and receivables
Ten Tips for Bootstrapping
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
Ten Tips for Bootstrapping
5) Pay with Equity
6) Use Underused Assets of Others
Use equipment during off-peak hours
Use meeting space of professionals
Use unused space of other businesses
Ten Tips for Bootstrapping
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
Ten Tips for Bootstrapping
9) Share Resources
10) Lead by Example
Sacrifice personal assets
Suggest ways to avoid cash outlays
UALR “Entrepreneurial Financing” February 9, 2004
Demand for Funds - Classifications of firms
Lifestyle Firms – provide a reasonable living for their founders, account for more than 90 percent of all start-ups it is unlikely that these firms will attract equity funding from external parties. These business ventures typically have five year revenue projections under $ 10 million.
Middle Market Firms – Have growth prospects of more than 20 percent annually and five year revenue projections between $10 and $ 50 million. These firms are attractive to business 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 Firms – Typically 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 $ 50 million and anticipate annual growth rates in excess of 50 percent. Typically financed by business angels and later by venture capitalists. These firms typically make up less than 1 percent of all start-ups.
On market projections, need to verify with top down and bottom up calculations. Can not say 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 Andersen’s 1995 national study 36 % of small, fast growing companies reported an inability to meet their capital needs.
Main Sources of Capital for 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 %
IPO’s and equity markets 3 % 10 % 26 %
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 technical jargon.
Investors want a plan for profit not an invention. Recurring revenue model and 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 are examples
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 or buy out of prior investors. Also investors want to see some investment by the founders, percentages are important (% of net worth)
Sweat Equity may be an issue. The investor wants to know what can you do to create value from this point on and how far along your are in the process helps determine valuation (risk/reward)
Executive Summary Outline
1. Our Business
2. Market Opportunity
3. Value Proposition
4. Proprietary or Distinguishable Position in the
5. Competition & Market Positioning Summary
Funds Requested and Why
Use of Funds with Expected milestones
Exit Strategy for Providers of Capital
Bootstrapping is the most likely source of initial equity for 94 percent of new technology based firms. It was initially used by more than 80 percent of the five hundred fastest growing privately held entrepreneurial firms in the United States.
Obtain Research Grants (SBIR etc.) or have customer funded R&D
Commercialize University Technology
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
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. Also bootstrapping is like zero inventory or JIT it reveals hidden problems and forces the company to solve them.
Success Rates for Obtaining Investment
77% of proposals rejected at the initial screening stage
20% rejected during the due diligence stage
1-3 % funded
Typically receive 36 investment proposals per year
Interested in 8
Offers made to invest in 2, T ypically find that 5% of deal flow result in a deal.
Angels are typically wealthy individuals/families willing to invest in high risk deals offered by entrepreneurs whom they admire and with whom they wish to be associated.
Speak with securities attorney before approaching outside investors, there are legal issues at stake. Investors may not know about the rules but they impact how the company raises capital over the subsequent 12 months. Typically equity 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 angels bring to fledging companies. Over 80% of angels have started a company on their own so they understand the process.
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 year than venture capitalists. The National Venture Capital Association has suggested that angels may actually invest around $ 100 billion annually. According to the Center for Venture Research there are 400,000 angels.
Angels tend to have less risk aversion and lower expectations of return than other types of investors. Their cost of finance is often cheaper for the entrepreneur and their funding is received more quickly than from other finance sources. Angels are more flexible in their financial decisions than venture capitalists.
Downsides include that angels are not likely to do multiple rounds, they may want a hands on role and be unqualified and they do not have the national reputation 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 a lead investor lives geographically close to the enterprise.
Angels tend to be men from 46-65 years of age. Age does seem to influence investors to this activity. In the 56-65 year old bracket investors tend to trust their own judgment rather than that of brokers or intermediaries. These investors tend to have postgraduate degrees. They have a wealth of business experience.
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. Holding period 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 angels will offer, in dollar terms, four times as much as venture capitalists.
Investors Investment Criteria (Rough Order) for All 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
Investor’s 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
Perfect Angel Investors
Industry Experience & Contacts
Additional Investment – Deep –but not to deep- pockets. Idea angel has personal net worth of $2 million to $50 million. If an angel has more than that your company may fall below their radar screen. If they have less you may be out of luck if you need follow on financing.
Congruent Exit Strategy
Investment Criteria for Angel Investors
Investor’s strengths in filling gaps
Investors involvement possible
Trustworthiness of entrepreneur
Quality of product
Low initial capital costs
Investor liked entrepreneur upon meeting
Low cost to market initially
Track record of entrepreneur
Sales potential of product
Growth potential of Market
Venture is local
Ability to break even without further funding
Formal competitive protection of products (patents)
Overall competitive position of product
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
Word of mouth. You want to come recommended.
Determine the ideal investors for your firm and follow a rifle approach.
Target lead investors
Check out potential investors – due diligence is a two way street
Local Angel Group. Most will not take cold calls so you will need a referral but once you are in angel groups offer an opportunity to present you company to several angels.
Professional Networks. Talk to professional service providers who may know angels.
Investee firms. Firms that have received angel money in the past introduce you to their angels
Personal Networks. Explore your network of friends, acquaintances and friend of friends.
Recent US research confirms that angels are widespread, at least 2.8 percent of US households have at least one angel in the family.
More than 50% of private equity investors deal flow comes from family, friends, associates and colleagues .
Snowballing. Find one business angel can lead to them knowing others. One caveat it is quality not quantity. For every venture no matter how unusual there is an angel out there willing to fund the idea.
Matchmakers. Be careful, ask for references and will they take the fees when you have the money.
Evaluating - Four Main Areas
People – you, the management team, other investors, advisors and significant stakeholders, anybody that has a stake in your companies success.
Unique Talent or Knowledge
Willingness to Hire Professional Management
Chemistry with Investors
Professional Advisors: Attorneys, Financial Advisors and Accountants
Context – external factors that could impact your business including available technology, customer needs, the overall economy, regulations and competitors
Deal – the price of the deal you propose and its structure. Price starts with valuation. Structure refers to the terms of the investment and other factors – board seats, salary limits, etc.
Business Opportunity – Your business model, market size, potential and actual customers and timing of your opportunity. Investors want to invest in a company not a single product remember the objective is to create wealth, not make a living
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 skills to do everything. Sell the Team as a Team
Show you have sales or can get them.
Make sure the deal you are proposing makes sense from the investors point of view. Tell the angels what is in it for them. Think through what the investors need to get out of the deal in terms of ownership and potential returns. Do not aim to squeeze every last nickel out of them.
From the beginning, you want investors always to feel as if they're making money
Discuss the exit strategy. Sell the company, go public et al and let them know the time frame for such an event.
Have the necessary documents in hand, business plan, financials, corporate bios etc.
Respect the angels time. Be punctual. Ask how much time they have for the meeting keep your answers short and to the point. If you do not know the answer don't fake it say you will find out and do it within a certain time frame.
Magic Words: “I Don’t Know.”
Know What Can Bite You and Say So
Address Tough Questions Before Asked/Answer the Questions When Asked
Never Oversell or Shade the Facts
Listen and Enjoy the Process
Weigh the pros and cons of angels before you being the search for and discussions with private investors. If angel investors are deemed appropriate form realistic expectations of roughly how much money you will need and how 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 can bring money and accounting assistance
Contrary to popular belief relatively few lawyers, doctors and other professionals are currently involved as angels.
Create Excitement around the Investment - After a handful of angels have expressed any degree of interest, you, the entrepreneur, should move interest into action and investment. Set a realistic deadline for the investment, then tell investors that the supply of available equity is fast dwindling.
Angels price the company based on its potential capital return in the future but realize their are non financial returns that accrue to the angel. Excitement of a start up, sense of contributing, opportunity to give something back to the entrepreneurial 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 point whether you and your team will be able to execute.
Valuation methods include:
free cash flow multiple,
discounted cash flow
Sales Forecast (Year 5) Under $ 50,000,000 Over $ 50,000,000
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.
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
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
The targeted rates of return on individuals deals have to be higher so that the portfolio can net acceptable returns. As a general rule investors target the following annual IRR’s:
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
First on what terms are the angels investing? Debt/equity, what type of debt/equity, will investors 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 silent partners or active ones?
Three fundamental ways angels invest in companies:
Easiest & Simplest
Same risk as founders
Little Structural Flexibility
Valuation set for future
Preferred Convertible Stock with various terms
Most Common Investment
Can Manipulate IRR
Upside guarantees, downside protection
Convertible note with various terms
Protection of principal
Interest as current return
Warrants as sweetener
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
Participating – rare in early deals
Full Ratchet - Draconian
Accounts and Reports
Approval of Budgets
Board of Directors
Independent Public Accountants
Class Voting Rights
Investor Can block important corporate transactions
Should disappear if preferred holds less than a certain percentage of company
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
Early In Issues
All vs. Pro Rata
Pay to Play
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 you against me.
During negotiations angels will tend to focus on the numbers, specifically their initial ownership stake. They believe that will have the greatest impact on the future return on their investment so many will bargain hard over it.
Angels have the advantage of time, you may need to move quickly they do not face the same time pressure. On the contrary many angels prefer 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 simply reject the deal and move on. There is no reason you can not take the same position put your best deal forward and say politely this is a take it or leave it position. If you are asked why say you do not want to start your relationship off on adversarial footing.
An angels investment should be just the beginning of the interaction not 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 regular updates to all investors. You may also want to put in key prospects or other key events and one of the investors may have a contact.
Getting the investors their money back plus a return. Typically in these forms:
Walking harvest – your company distributes cash directly to its investors on a regular basis.
Partial Sale – your investor sell their stakes to your company’s management another 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 for its cash flow.
Initial Public Offering – your company sells stock in the public markets. Less experienced angels, overemphasize the IPO as a primary exit route. An IPO is the exception not the rule.
Negative Harvest - bankruptcy
Of the nearly one million firms that are started each year in the United States only one to two thousand actually receive venture capital financing.
Venture Capitalists are rarely able to fund small start up firms seeking less than $ 5 million, regardless of the quality of the venture because of their 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
Types of Venture Funds
Stage of Investment
Computer Science Medical
Venture Funds as Partnerships
Object is to create Large, Successful Companies, make Outstanding Returns on the Fund’s Capital - 25%+ IRR for Limited Partners and to Permit the Venture Capitalist to Share in Profits over a typical 10-Year Term
Investors are Limited Partners
Invest 99% of Capital
Receive Capital Return First, Then 80% of Profit
No Role in Decisions
Venture Capitalists are General Partners
Invest 1% of Capital
Receive 20% of Profits
Make All Decisions
Initial Public Offerings
An IPO typically has to be in the $20 - $50 million range to create a market for a firm.
At the IPO stage providing financing for the firms growth is usually not the major motivation, rather procuring exit routes and share liquidity is primary.
The SBA estimates that fewer than one in a thousand new ventures actually have an IPO.
In the United States, it is estimated that only 1 percent of corporations are publicly 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 funded firms.
Never split equity 50/50, and don’t 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 external board.
Investment due diligence is about intgretity. It is about can I trust you? Will you make the right decisions with my money?
Big money brings big expectations. You may not be with the company to accomplish those expectations.
Perception is reality – everybody likes a winner and wants to avoid a losing image.
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 avoid down rounds.
Get an external confidant to act as a sounding board, they will help you keep a level plane
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 -- A Guide for Entrepreneurs, Individual Investors, and Venture Capitalists - Robert J. Robinson & Mark Van Osnabrugge