Sources of Capitalfor Entrepreneurial Firms   Harry J. Sapienza, PhD.   University of Minnesota        Ozyegin University,...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections          25 Years of Studying  Ven...
Introduction     Fund Sources        Formal VC                      Informal VC   Reflections    Studies/ data collected o...
Introduction    Fund Sources      Formal VC                    Informal VC   Reflections               Outline of Today’s ...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections               New Venture Money:  ...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections               Typical Sources of F...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections      How Stage or “Burn Rate” affe...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections        How Growth Goals (or lack o...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections                  Preferences for  ...
Introduction    Fund Sources      Formal VC                    Informal VC   Reflections                   Serial vs. Firs...
Introduction   Fund Sources        Formal VC                      Informal VC   Reflections   Single versus Multiple-found...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections      Informal and Formal Investors...
Introduction   Fund Sources     Formal VC                   Informal VC   Reflections                VCF Structure in U.S....
Introduction   Fund Sources     Formal VC                   Informal VC   Reflections       The Formal Venture Capital Cyc...
Introduction    Fund Sources      Formal VC                    Informal VC   Reflections               Pre-Investment Acti...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections        Criteria for Venture Select...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections           Valuation and Negotiatio...
Introduction     Fund Sources     Formal VC                   Informal VC   Reflections               Once the First Money...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections               Good Times and Bad  ...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections                                   ...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections               Goal Differences Amo...
Introduction    Fund Sources      Formal VC                    Informal VC   Reflections     The Rise of Sophisticated Ang...
Introduction    Fund Sources     Formal VC                   Informal VC   Reflections    Key Aspects of Business Angel In...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections  Portrait of a ‘Typical’ U.S. Busi...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections               Business Angels Arou...
Introduction      Fund Sources      Formal VC                    Informal VC   Reflections               Angel vs. VC Char...
Introduction   Fund Sources     Formal VC                   Informal VC    Reflections               Investment Motivation...
Introduction     Fund Sources       Formal VC                    Informal VC   Reflections        Sampling of Top Investme...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections       Significant Differences in A...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections    Recent Experience as Angel Inve...
Introduction   Fund Sources     Formal VC                   Informal VC   Reflections   Reflections from Research, Practic...
Introduction    Fund Sources      Formal VC                    Informal VC   Reflections               Advice to Entrepren...
Introduction   Fund Sources      Formal VC                    Informal VC   Reflections                          Conclusio...
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Sources of Capital for Entrepreneurial Firms

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Presentation of Phd. Harry J. Sapienza from University of Minnesota @ Ozyegin university in Istanbul, July 2012

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  • Torah and Qur’an Moses, Plato, Aristotle, Cato, Cicero, Mohammed, Aquinas Cicero’s De Re Rustica : ‘And, what do you think about usury? Well, what do you think about murder?’ Qur’an…’Those engaging in usury are in the same position as those under the devil’s influence…’
  • Each source has different requirements/ motives Each source has different advantages/ disadvantages In the ideal, what would an ideal provider of funds be— One that had as much money available as needed, available without delay each time it is needed would charge very little for the use of their money -would give as much time as needed to pay back, without penalty -would leave all decisions in the entrepreneurs’ hands without interference Now let us consider each of the sources above and see how they fit, and what they would require
  • Proven ability to create and run a venture… a difficult and all-consuming task of --persuasion (team members, financiers, customers, suppliers, etc. --organization and dedication --persistence, optmism and realism Proven willingness to grow and move on… One of the key factors for investors is to gauge the willingness of the founders to turn control over if needed Team -- individual talents, energy – without redundancy -- proven ability to work together to solve problems, discover paths
  • "When the young Alexander Graham Bell needed money in 1874 to complete his early experiments on the telephone, bank officers thought that the idea of a telephone was a foolish one. The consensus was that the nation had a workable communication system in the form of the telegraph, and the concept of individuals communicating across great distances through speech was considered to be a bit extreme. Besides, Mr. Bell did not have a company with any tangible assets to provide collateral. Recognizing an opportunity, Boston attorney Gardiner Green Hubbard and leather merchant Thomas Sanders of Salem, Massachusetts put up the equity capital to start the Bell Telephone Company in Boston, Massachusetts.” -"In 1903, when Henry Ford was in need of capital at the early stage in the development of the automobile, he faced difficulties in securing funding to develop a working prototype. The owner of Daisy Rifle, along with four other individuals, came to the rescue and invested $40,000 in equity capital. ” - “About 100 years later, in 1976, when Anita Roddick needed capital to open a second store, her bank responded that she had only been in business a few months, she had no track record, and that she should wait another year. For an entrepreneur, a year is an eternity. Ms. Roddick turned to a private investor, Ian McGlinn, who invested [$85,000] that she needed. She opened that second store and so began the development of Body Shop, a corporation with over 700 stores today.” - " In 1994 Jeff Bezos and a few employees created a web site and data base in Bezos's Bellevue, Washington garage. He went looking for capital from venture capital firms but their response became a familiar one: ‘Good idea but, well, maybe later.’ After being introduced to some private investors, he succeeded in raising $1.2 million from a dozen private investors. A later round of $8 million was provided from professional venture capital funds. In May 1997 the company Amazon.com, the internet bookseller, completed an initial public offering, providing the investors and entrepreneurs with a handsome return.” -
  • “ Institutional investors are much more rigorous and our criteria are tougher because we are doing the investment for only one reason, that is to deliver returns to outside investors whose funds we manage. We should not be making investments because we like working with or in a business. Angel investors invest their own money and are entitled to, and they probably make investments based on very soft financial criteria" (VC quoted in van Osnabrugge, p.241)
  • Many of the VCs’ ratings were extremely similar to BAs. For example, Entr trustworthiness and enthusiasm were top two for VC and Sales potential was number three. Deeper analyses showed systematic areas in which criteria differed significantly even if overall ratings were highly similar
  • Sources of Capital for Entrepreneurial Firms

    1. 1. Sources of Capitalfor Entrepreneurial Firms Harry J. Sapienza, PhD. University of Minnesota Ozyegin University, July 25, 2012
    2. 2. Introduction Fund Sources Formal VC Informal VC Reflections 25 Years of Studying Venture Capitalists and Entrepreneurs • How do VCs create, manage a portfolio of investments? What influences success? • What roles do Investors play? How similar/ different are these around the world? • When do investors add more than money? • When do entrepreneurs learn from investors? • When do investors learn from entrepreneurs? • What are causes and effects of conflict? • How do investors make “gut” level judgments? Ozyegin University, July 25, 2012
    3. 3. Introduction Fund Sources Formal VC Informal VC Reflections Studies/ data collected over time• VC Roles, VC-Entrepreneur conflict, valuation of investors, U.S.• Roles, valuation of investors, UK, France, Belgium• Roles of investors, Asia• Target returns U.S., Europe, Asia• Information exchange, fairness, U.S.• “Ideal” contracts and role of trust, U.S.• Syndication, reputation, involvement, U.S., Europe• Learning by Investors, U.S.• Decisions to Terminate or Exit at a Loss, U.S.• Innovation and “Angel” Investor roles, U.S., Europe• Business models and investors, Europe• Entrepreneurs use of Story and investor evaluations, U.S.• Signals of Competence and Integrity and Investor evaluations Ozyegin University, July 25, 2012
    4. 4. Introduction Fund Sources Formal VC Informal VC Reflections Outline of Today’s Topics • (Outside) Sources of a Venture’s lifeblood • “Appropriateness” of Sources • Goals and Types of Entrepreneurs • Tapping into venture capital– often an uneasy marriage: Formal and Informal Venture Capital • Formal (Institutional) VC • Comparison of formal VC and informal VC • Research Reflections on VC-E Relationships Ozyegin University, July 25, 2012
    5. 5. Introduction Fund Sources Formal VC Informal VC Reflections New Venture Money: A Messy Proposition • The typical entrepreneur does not want to grow his business to extremely large proportions • However, even modest startups often need more money to get going than is available • This is where lending or investing starts… A necessary evil? Ozyegin University, July 25, 2012
    6. 6. Introduction Fund Sources Formal VC Informal VC Reflections Typical Sources of Funds• Own savings/ earnings• 3F’s: Family, Friends, other Fools• Customer advances, Supplier Credit• Bank Loans• Government loans, grants, etc.• Private individuals (“Angels”)• Angel syndicates• Private Venture Capital, (Gov’t Venture Capital)• Corporate Venture Capital Ozyegin University, July 25, 2012
    7. 7. Introduction Fund Sources Formal VC Informal VC Reflections How Stage or “Burn Rate” affects Appropriateness of Sources • Development and pre-sales • Early sales • Growth • (Somewhat) Steady state Ozyegin University, July 25, 2012
    8. 8. Introduction Fund Sources Formal VC Informal VC Reflections How Growth Goals (or lack of) Affect Appropriateness of Sources • Most funding sources do not necessarily care whether you seek to grow rapidly or not. • For institutional venture capital, rapid growth in the period following investment is critical • For most business angels growth will be important but need not be as dramatic • For corporate venture capital, growth is good but technology or customer space may suffice Ozyegin University, July 25, 2012
    9. 9. Introduction Fund Sources Formal VC Informal VC Reflections Preferences for Control Versus Return • ‘Passion’ about the venture may take several forms– e.g., – passion to build the best technology, – to solve an important or personal problem – to create something for the family – to create an organization one can run well • From an equity point of view the key is, how important is it to maintain control? Ozyegin University, July 25, 2012
    10. 10. Introduction Fund Sources Formal VC Informal VC Reflections Serial vs. First time or one time Entrepreneurs • “Serial” entrepreneurs, ones who have created several successful ventures, are very attractive to equity investors. Why? • An untested, first time entrepreneur is risky • The team of founders may be most critical; Yet, there must be a leader Ozyegin University, July 25, 2012
    11. 11. Introduction Fund Sources Formal VC Informal VC Reflections Single versus Multiple-founder Firms • The later the stage, the more important to have a complete team • Some investors like to have a hand in filling out the team, but generally speaking a team of top-notch people is very positive --attracting great talent is a sign of value, charisma --having no redundant or useless parts is a sign of the organizational and business judgment of the leader Ozyegin University, July 25, 2012
    12. 12. Introduction Fund Sources Formal VC Informal VC Reflections Informal and Formal Investors • Much more is known about private, institutional venture capital firms (VCFs), though private individual investors (business Angels) have been around as long commerce has existed • We begin with formal venture capital, then compare what is known about business angel investing and how it has learned from formal VCFs Ozyegin University, July 25, 2012
    13. 13. Introduction Fund Sources Formal VC Informal VC Reflections VCF Structure in U.S. • VCFs are organized as general partnerships, typically 3-10 partners and a staff that works on information gathering, communication, etc. • At any point in time, the VCF will have several “funds” to manage, each with a limited life, typically of 10 years, maturing at various times • Limited partners “own” the funds VCFs manage, and limit their liability by leaving fund management to the VCFs Ozyegin University, July 25, 2012
    14. 14. Introduction Fund Sources Formal VC Informal VC Reflections The Formal Venture Capital Cycle • Raising a Fund from Limited Partners – Track record of General Partner VCs – Investment climate and money availability • Screening Criteria for potential investments • Due diligence • Deal negotiation • Portfolio management (next cycle begins here) • Exits and fund termination Ozyegin University, July 25, 2012
    15. 15. Introduction Fund Sources Formal VC Informal VC Reflections Pre-Investment Activities • Establishing a 10 year limited partnership; conditions and terms (typically management fee, “carry,” restrictions on the general partners’ decisions and activities– no direct say in management of investees) • Raising a fund • Searching for a pool of viable investments • Investigating only the top prospects • Negotiating 1st round of investment, investment rights Ozyegin University, July 25, 2012
    16. 16. Introduction Fund Sources Formal VC Informal VC Reflections Criteria for Venture Selection • Quality of Top Management Team, Lead Entrepreneur • Market Size, Competitiveness, Growth Potential • Viable Exit Routes • Significant barrier to Duplication Ozyegin University, July 25, 2012
    17. 17. Introduction Fund Sources Formal VC Informal VC Reflections Valuation and Negotiation • Use of Selection Criteria • Setting ‘pre-money’ valuation is a backwards process • Setting terms to – protect right to participate in success, – minimize damage (to extent possible) in failure • Negotiate information rights, board seats, future equity fund raising, hiring Ozyegin University, July 25, 2012
    18. 18. Introduction Fund Sources Formal VC Informal VC Reflections Once the First Money Is In • Typically, monthly reports are sent to investors, focusing on progress on “milestones” • Board meetings may be bi-monthly or quarterly, with frequency highest at earliest stage • Boards most often around 5 people: VCFs having 2 or 3 seats, 1 expert outsider, 1 or 2 managers • Money is put into the venture in “rounds” and “tranches”– serving several purposes Ozyegin University, July 25, 2012
    19. 19. Introduction Fund Sources Formal VC Informal VC Reflections Good Times and Bad • Investors expect most of the ventures to be disappointing-- most returns come from few • The difficulty is determining whether to keep the venture on life-support, or terminate • Rough times are common; decision is not trivial. Investors vary in incentive to continue • When things are going well, the toughest decision may be about leadership transition Ozyegin University, July 25, 2012
    20. 20. Introduction Fund Sources Formal VC Informal VC Reflections Exits • Happy exits: – In some cases, management buyback, – Most commonly, acquisition or trade sale – Highly desirable (in most ways) to investors, is the initial public offering • Not-so-happy exits: – Liquidation or buyback Ozyegin University, July 25, 2012
    21. 21. Introduction Fund Sources Formal VC Informal VC Reflections Goal Differences Among Investors • Often the greatest conflict regarding the fate of ventures has to do with the circumstances of the investors. Things that may cause these differences include: – Differential liquidation rights – Inability to participate in further equity rounds – Differences in time horizons or needs for cash Ozyegin University, July 25, 2012
    22. 22. Introduction Fund Sources Formal VC Informal VC Reflections The Rise of Sophisticated Angels • Long history of ‘Private’ Investors • Angel Investing is “venture capital-equity investments made by private individuals, directly in unquoted companies in which they have no family connection...” • It fills the gap between founders, family and friends and institutional venture capital funds • substantially larger than formal VCF market -- in terms of amount invested in businesses at their start-up -- and in terms of the number of such deals made in early stages Ozyegin University, July 25, 2012
    23. 23. Introduction Fund Sources Formal VC Informal VC Reflections Key Aspects of Business Angel Investing • Unlike family/ friends, “arms length” relationships • Unlike VCs, BAs are investing their own money • BAs typically cannot get the same equity per $/TL as VCFs • Significant barriers to linking BAs and entrepreneurs • Estimated – 3x to 5x the money; – 40x the number of deals • Countries, regional authorities, entrepreneurs, and BAs have all tried to increase connections Ozyegin University, July 25, 2012
    24. 24. Introduction Fund Sources Formal VC Informal VC Reflections Portrait of a ‘Typical’ U.S. Business Angel (circa 2000) • Age 47-54 years old • Sex Male • Annual family income ~$100,000 • Net worth ~$2 million • Experience Extensive, some entrepreneurial • Education Bachelor’s; half with advanced • Number of investments 2 every three years • Investment rate in 8% of deals • Average amount invested $60,000 • Preferred stage Startup 56%; Earlier 24% • Co-investment Formerly alone, now syndicating • Control 56% have minority voting position Ozyegin University, July 25, 2012
    25. 25. Introduction Fund Sources Formal VC Informal VC Reflections Business Angels Around the World • Evidence suggests that the profile of business angels is similar around the world • Typical investment in ‘chunks’ of – $10,000 – $25,000 – $50,000* mode – $100,000 – $250,000 • BA investing recent trends – More sophistication in diligence, terms, negotiations – More syndication Ozyegin University, July 25, 2012
    26. 26. Introduction Fund Sources Formal VC Informal VC Reflections Angel vs. VC Characteristics and Practice • VCs have more investing experience • BAs have more startup management experience • VCs have wider, more consistent access to new deal flow • VCs ‘share’ flow more • BAs conduct less due diligence • BAs use less routinized valuation Quote from Angel: “...I rely less on the numbers, but more on the subjective impression of the entrepreneur--it has to feel right and I have to believe in it. I dont have to be analytical, I can go on instinct unlike the venture capitalist. I dont have to rationalise my investment decision to a boss at the end of the day" Ozyegin University, July 25, 2012
    27. 27. Introduction Fund Sources Formal VC Informal VC Reflections Investment Motivations of Angels Angels rate making money highest, but two other motivations are also important: Realize financial gain 4.09 rating out of 5 Play role in entrepreneurial process 3.68 rating out of 5 Have fun, achieve satisfaction 3.68 rating out of 5 “...I feel this is a fantastically exciting sport!” Angel quote Van Osnabrugge, 1999* Ozyegin University, July 25, 2012
    28. 28. Introduction Fund Sources Formal VC Informal VC Reflections Sampling of Top Investment Criteria for Angels Comparison with VCs 1. Enthusiasm of entrepreneur 4.69 2. Trustworthiness of entrepreneur 3. Sales potential 4. Expertise of entrepreneur 4.33 5. Likes entrepreneur upon meeting 6. Growth potential of market 7. Quality of product 4.15 8. Investor involvement possible 9. Able to reach break even without more funding 10. Low initial expenses 3.44 11. Is local 12. Investor understands business/industry 13. Good potential exit routes 3.12 Above scale is of importance of criterion from 1= not important, 3= somewhat important, and 5= extremely important Ozyegin University, July 25, 2012
    29. 29. Introduction Fund Sources Formal VC Informal VC Reflections Significant Differences in Angels’ and VCs’ Criteria• In comparison to VCs, Angels – rely less on the expected financial return criterion – are more concerned with cost containment criteria – focus less on entrepreneur’s track record & expertise – are more concerned the venture is nearby – are more insistent on being operationally involved – are more interested when own strengths fill venture gaps – rely less on the business plan – are less concerned that a clear exit path exists Ozyegin University, July 25, 2012
    30. 30. Introduction Fund Sources Formal VC Informal VC Reflections Recent Experience as Angel Investor • “Bands of Angels” becoming common • Sophistication / professionalism of practice increasing, but still much “solo flying,” and still much room for personal motives • Loose organization like herding cats • Dedication, risk-taking on individual level varies widely • What I like… Ozyegin University, July 25, 2012
    31. 31. Introduction Fund Sources Formal VC Informal VC Reflections Reflections from Research, Practice • Quality of relationship is very important in rough times– times are rough more often than not • Process favors those with greater stack of money • The closer the relationship the more conflict, but also more satisfaction (all else equal) • A venturing ‘community’ tends to develop in areas with great activity; reputation is critical • ‘Gut feel’ and group process play big roles • Entrepreneurs are optimists, investors are pessimists Ozyegin University, July 25, 2012
    32. 32. Introduction Fund Sources Formal VC Informal VC Reflections Advice to Entrepreneurs • Seek appropriate sources of funding • Understand yourself– is control of the creation more important than wealth realization? • If you do take VC, do your own due diligence • Understand that investors’ want to get out with as much as they can as soon as they can • Keep the investor informed throughout the relationship; honesty and openness lead to better terms, more leeway Ozyegin University, July 25, 2012
    33. 33. Introduction Fund Sources Formal VC Informal VC Reflections Conclusion • I have found this process to be a fascinating blend of the personal and the impersonal • It is about making good, well-considered decisions in the face of tremendous uncertainty: persistence, determination, and risk-taking with reason • It is also very much about people. This should be not be forgotten. Ozyegin University, July 25, 2012
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