Intro to Finance


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Intro to Finance

  1. 1. Introduction to basic issues in entrepreneurial valuation High Technology Entrepreneurship Prof. Scott Jones Thanks to David J. Freschman, CPA, Delaware Innovation Fund and Mark J. Gundersen, Esq., McCarter & English for contributing Some material used in this presentation.
  3. 3. Selecting a Business Entity (what is the legal structure of the Owner’s Equity?) <ul><li>Sole Proprietorship </li></ul><ul><li>General Partnership </li></ul><ul><li>Limited Partnership </li></ul><ul><li>Limited Liability Company * </li></ul><ul><li>Subchapter S Corporation* </li></ul><ul><li>Subchapter C Corporation* </li></ul>
  4. 4. Factors to Consider <ul><li>Start-up Economics (Net Operating Losses) </li></ul><ul><ul><li>Flow through type (income passed fully to owners) </li></ul></ul><ul><ul><li>C Corp. type (income passed as dividends) </li></ul></ul><ul><li>Projected Growth </li></ul><ul><li>Source of capital (founders, VCs, etc.) </li></ul><ul><li>Exit Strategy </li></ul><ul><li>Limited Liability </li></ul><ul><li>Employee Incentives </li></ul><ul><li>Tax Issues </li></ul>
  5. 5. Prepare Documents <ul><li>Business Plan </li></ul><ul><li>Executive Summary </li></ul><ul><li>Brief Venture Pitch </li></ul><ul><li>Elevator speech </li></ul><ul><li>PPM </li></ul>
  6. 6. Wrap-up legal issues <ul><li>IP (patents, copyrights, trademarks) & assignments </li></ul><ul><li>NDAs, non-compete in place w/ employees </li></ul><ul><li>Board members- add value </li></ul><ul><li>Consulting agreements (work for hire) </li></ul><ul><li>Web-site, name trademarked </li></ul>
  7. 7. How Do Entrepreneurs Raise Money? <ul><li>Sweat Equity (Bootleg) </li></ul><ul><li>SBIR </li></ul><ul><li>Friends, Family, Fools </li></ul><ul><li>Banks </li></ul><ul><li>Savings, 2 nd Mortgage, etc. </li></ul><ul><li>Angels </li></ul><ul><li>Venture Capitalists </li></ul>
  8. 8. Small Business Innovation Research <ul><li>Federal Agency (DOD, EPA, NSF, NASA, etc.) </li></ul><ul><li>Phase I- Evaluate Scientific & Technical merit ($100k) </li></ul><ul><li>Phase II- R&D activity- prototype, clinical trials, etc. ($750k) </li></ul><ul><li>Phase III- Commercialize- no money but expedited procurement </li></ul><ul><li>Topics vary by agency </li></ul><ul><li>For profit company, <500 employee, 51% US owned, PI must be employee, not employed FT elsewhere </li></ul><ul><li>Gov’t gets use royalty free, but recipient gets worldwide patent rights </li></ul><ul><li>6-18 month funding gap </li></ul><ul><li>Can’t hire marketing/sales staff- scientific/R&D only </li></ul>
  9. 9. Angels <ul><li>Wealthy individuals </li></ul><ul><li>May be, but not necessarily “accredited investors” </li></ul><ul><li>Typically interested in- some return, philanthropic interest, want to be active </li></ul>
  10. 10. Venture Capital <ul><li>Most businesses do not use VC money </li></ul><ul><li>Many successful technology startups eventually use VC money </li></ul><ul><li>Typical “Fund” </li></ul><ul><ul><li>10 year limited partnership </li></ul></ul><ul><ul><li>May make 10 to 15 investments </li></ul></ul><ul><ul><li>LPs provide capital </li></ul></ul><ul><ul><li>VC professionals do the investing </li></ul></ul><ul><ul><li>Both share in the carried interest (profit after return of investment capital to LPs) </li></ul></ul>
  11. 11. The Venture Capital Industry A Typical Fund General Partner (VC Firm) 1% of Capital 2.5% Mgmt. Fee 20% Carry Newco A Newco B Newco C Newco N Megaco A Bigco B Hanginginco C Loserco N Limited Partners 99% of Capital 80% Carry $ $ $ Expertise X $ $ $
  12. 12. Trading Securities <ul><li>Public traded: NYSE, AMEX, NASDAQ </li></ul><ul><ul><li>Requires SEC registration </li></ul></ul><ul><ul><li>Fees </li></ul></ul><ul><ul><li>Must comply w/ Act of ’34 & requirements of Regulation S-X (17 CFR 210). </li></ul></ul><ul><ul><li>SEC report filing (10Q/K, 8K) </li></ul></ul><ul><ul><li>Follow GAAP </li></ul></ul><ul><ul><li>Audited Financial Statements </li></ul></ul><ul><li>Private placements </li></ul><ul><ul><li>No SEC registration </li></ul></ul><ul><ul><li>Generally want to follow GAAP, no SEC filings </li></ul></ul><ul><ul><li>Be careful to follow rules </li></ul></ul>
  13. 13. Private Placement Memorandum <ul><li>Mission/objective </li></ul><ul><li>Capitalization & shareholders </li></ul><ul><li>Company & Management (mini Bus plan) </li></ul><ul><li>Financial </li></ul><ul><li>Legal </li></ul><ul><li>Exhibits </li></ul>
  14. 14. Legal issues & Investment Capital <ul><li>Impractical for small company to register (cost) </li></ul><ul><li>Comply to avoid contingent liability (Right of rescission) </li></ul><ul><ul><li>Section 4(2) exemption </li></ul></ul><ul><ul><ul><li>Sophisticated investors have access to information (i.e., like prospectus), no solicitation- VC fund </li></ul></ul></ul><ul><ul><li>Regulation D- Rules 501-508 Provide “Safe Harbor” </li></ul></ul><ul><ul><ul><li>Size of offering, limits to unaccredited investor group size </li></ul></ul></ul><ul><ul><ul><li>Accredited Investors </li></ul></ul></ul><ul><ul><ul><li>Can’t “advertise” the offering </li></ul></ul></ul><ul><ul><ul><li>Provide Information </li></ul></ul></ul><ul><ul><li>Rule 701- Benefit plans or written compensation agreement </li></ul></ul>
  15. 16. Basic Accounting Equation ASSETS = LIABILITIES + OWNERS EQUITY Stuff that has future economic benefit: cash, receivables, inventory, patents, equipment, etc. Things I owe to to other people: payables, tax liabilities, loans, mortgages, etc. What’s left over is mine. Like the basic laws of physics, this equation cannot be out of balance.
  16. 17. Valuation Problem <ul><li>A = L + OE </li></ul><ul><li>Founders put in $100,000 of savings to buy computer equipment to start company. </li></ul><ul><li>100,000 = 0 + 100,000 </li></ul><ul><li>Founders get $1,000,000 of venture money to hire employees & expand sales effort </li></ul><ul><li>1,100,000 = 0 + 1,100,000 </li></ul><ul><li>How much of the company do the founders own? The VCs own? </li></ul>
  17. 18. Depends on “valuation” <ul><li>It is all subject to negotiation, but a starting point is the “theoretical” VC valuation model: </li></ul>Ownership % needed = Required future value of investment Total terminal value of the investment VALUATION is NOT the same thing as ASSETS
  18. 19. Required future value of investment = (1 + IRR) n (I o ) Total terminal value of the investment = (P/E)(E n ) IRR = VCs required internal rate of return I 0 = Investment at t=0 P/E = Price to Earnings ratio for companies in that industry E n = Earnings in terminal year (n) of investment (exit point) Ownership % needed = (1 + IRR) n (I o ) (P/E)(E n ) (at exit)
  19. 20. Ownership % needed = Solve this for “Vo”, to get the pre-money valuation- this is the “value” that the VC gives the founders. = (1 + IRR) n (I o ) (P/E)(E n ) The following relationship must also hold true: I o V o + I o I o V o + I o
  20. 21. Number of new shares = To give investors % ownership required (1-% ownership required) Price per Share = No. of new shares Amount Invested * (number of old shares)
  21. 22. Example (continued) <ul><li>Assume technology company (P/E around 10.3), early stage investment requiring 35% IRR, expected exit 5 years, projected earnings at 750,000 in 5 th year </li></ul>% = (1 + 0.35) 5 (1,000,000) 10.3(750,000) = 58%
  22. 23. Example (continued) <ul><li>Founders issued themselves 50,000 shares for the initial investment of $100k, or $2 per share. The new share price is: </li></ul>No. new shares = .58 (1-.58) = 69048 *50000 Share price = 1,000,000/69048 = $14.48 THIS WAS AN “UP ROUND” FOR THE FOUNDERS!
  23. 24. Other issues <ul><li>Type of stock VC’s take is often “convertible preferred stock”- class of stock that has the preferences of debt, but the ownership rights of common stock </li></ul><ul><ul><li>Preference in liquidation (perhaps even a multiple) </li></ul></ul><ul><ul><li>Dividends accrue if unpaid </li></ul></ul><ul><ul><li>Converts to common in an IPO </li></ul></ul><ul><ul><li>Has anti-dilution protection </li></ul></ul><ul><li>Usually get board seats </li></ul>
  24. 25. “B” round financing Suppose that the example company needs $2,000,000 one year later. A second VC fund now joins the first, they each put in half. But the Pre-money value is set at $500,000. Ownership % needed = = $2,000,000 $500,000+$2,000,000 Ownership % needed = 80% The VCs will now want 80% of the stock. I o V o + I o
  25. 26. Number of new shares = To give investors % ownership required (1-% ownership required) Price per Share = No. of new shares Amount Invested * (number of old shares)
  26. 27. Number of new shares = To give investors Price per Share = (.8/.2) * (119048) = 476,192 2,000,000/476,192 = 4.20 This is a “down round” for the original investors.
  27. 28. VCs protect their ownership percentages with Anti-dilution provisions <ul><li>Preemptive rights: investors maintain their percentage ownership in the company by purchasing a pro rata share of stock sold in future financing rounds. </li></ul><ul><li>Anti-dilution protection: adjusts the investors’ ownership percentages if the company effects a stock split, stock dividend, or recapitalization. </li></ul><ul><li>Price protection: adjusts the conversion price at which the preferred stock can be converted into common stock if the company issues stock at a price below the current conversion price of the preferred stock to protect from the risk that the pre-money valuation turns out to be too high. </li></ul><ul><ul><ul><li>A full ratchet adjusts the conversion price to the lowest price at which the company subsequently sells its common stock regardless of the number of shares of common stock the company issues at that price. </li></ul></ul></ul><ul><ul><ul><li>A weighted average ratchet adjusts the conversion price according to a formula that takes into account the lower issue price and the number of shares that the company issues at that price. </li></ul></ul></ul><ul><ul><ul><li>(Source: Hutchison and Mason PLLC, Structuring Venture Capital Investment) </li></ul></ul></ul>
  28. 29. VC Ratchet: Receives rights to convert stock based on lowest subsequent issue price Original capitalization table, or “CAP” Table: # Shares % Founders 50,000 42 Investor A 69,048 58 Suppose 3 months later there is a cash crunch and Grandma comes in for 10,000 shares at $5.00. Obviously A is unhappy because he or she paid $14.48 per share. If this is a VC with a full ratchet clause, A would receive rights to convert based on the lowest subsequent issue price. This is done to protect A’s rights for having taken the initial risk providing the bulk of the capital, and to avoid management from diluting VC’s ownership.
  29. 30. VC Ratchet The ratchet factor is $14.48/$5.00= 2.9 . So A gets rights to 69048*2.9=199,963 shares of common stock (130,915 additional for no additional investment.). New CAP Table: Before Ratchet After Ratchet # Shares % #Shares % Founder 50,000 39 50,000 19 Investor A 69,048 54 199,963 77 Grandma 10,000 7 10,000 4 Total 129,048 259,963 Note the ownership dilution came out of the Founder’s share. (Figures shown are fully diluted)