Chapter 11


Published on

Published in: Economy & Finance, Business
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Chapter 11

  1. 1. Chapter 11 Human and Financial Capital McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. Human and Financial Capital <ul><li>Sources of human capital </li></ul><ul><li>Sources of financial capital </li></ul><ul><li>Pitching to investors </li></ul><ul><li>Valuing a startup </li></ul><ul><li>Negotiating with investors </li></ul><ul><li>IPOs </li></ul>
  3. 3. Venture Capital — Market Size, 1995-2001 Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report .
  4. 4. Business Startup <ul><li>The process of developing infrastructure needed to support growth </li></ul><ul><li>Engage in three basic processes: </li></ul><ul><ul><li>develop / refine the offering and strategy to go to market </li></ul></ul><ul><ul><li>obtain initial funding to begin operations </li></ul></ul><ul><ul><li>build a capable management team to handle operations </li></ul></ul>
  5. 5. Startup Business Investment Stages Seed Stage Financing Stages Investment Purpose Type of Investors <ul><ul><li>Validate the business concept (e.g. build prototype, develop business plan, conduct market research) </li></ul></ul><ul><ul><li>Angel investors </li></ul></ul><ul><ul><li>Traditional VC </li></ul></ul><ul><ul><li>Consulting firms </li></ul></ul><ul><ul><li>Online VC firms </li></ul></ul><ul><ul><li>Incubators </li></ul></ul>Startup <ul><ul><li>Build management team and complete product development </li></ul></ul><ul><ul><li>Angel investors </li></ul></ul><ul><ul><li>Traditional VC </li></ul></ul><ul><ul><li>Consulting firms </li></ul></ul><ul><ul><li>Incubators </li></ul></ul>First-Stage <ul><ul><li>Expand production, marketing, or sales capabilities </li></ul></ul><ul><ul><li>Traditional VC </li></ul></ul><ul><ul><li>Corporations </li></ul></ul>Second-Stage <ul><ul><li>Provide working capital once shipping products or providing services </li></ul></ul><ul><ul><li>Traditional VC </li></ul></ul><ul><ul><li>Corporations </li></ul></ul>Mezzanine <ul><ul><li>Fuel substantial growth (typically provided to business that are at least break even) </li></ul></ul><ul><ul><li>Traditional VC </li></ul></ul><ul><ul><li>Corporations </li></ul></ul><ul><ul><li>Buyout firms </li></ul></ul><ul><ul><li>Investment banks </li></ul></ul>Bridge <ul><ul><li>Prepare for initial public offering, usually planned in the next 6 months to a year </li></ul></ul><ul><ul><li>Traditional VC </li></ul></ul><ul><ul><li>Corporations </li></ul></ul><ul><ul><li>Buyout firms </li></ul></ul><ul><ul><li>Investment banks </li></ul></ul>Source: Gold Book of Venture Capital Firms, Bob Zider, “ How Venture Capital Works,” Harvard Business Review Early Stage Expansion Stage Later Stage
  6. 6. Human and Financial Capital <ul><li>Resources influence the business planning process and, </li></ul><ul><li>In turn, are influenced by the business plan </li></ul><ul><li>Human capital resources include </li></ul><ul><ul><li>entrepreneurs, management team, strategic advisors and partners, and logistical advisors and partners </li></ul></ul><ul><li>Financial capital resources include </li></ul><ul><ul><li>debt financing and equity financing </li></ul></ul>
  7. 7. Human and Financial Capital Entrepreneur Management Team Strategic Advisors & Partners Logistical Advisors & Partners Human Capital Business Planning Process Financial Capital Trade Credit Commercial Bank Loans Debt Bootstrapping Angels Venture Capital Corporate Ventures Equity Holding Company
  8. 8. Business Planning Process <ul><li>Define the value proposition </li></ul><ul><li>Frame the market opportunity </li></ul><ul><li>Detail how to reach customers </li></ul><ul><li>Develop an implementation plan </li></ul><ul><li>Evaluate potential external influences </li></ul><ul><li>Articulate the revenue model </li></ul><ul><li>Identify needed people </li></ul><ul><li>Calculate preliminary financial projections </li></ul><ul><li>Establish critical milestones </li></ul><ul><li>Summarize the advantage </li></ul>
  9. 9. Human Capital <ul><li>Especially critical for startup because, for a time, it is the only resource available </li></ul><ul><li>Investors considering early-stage funding assess its human capital </li></ul><ul><ul><li>Who is the entrepreneur? </li></ul></ul><ul><ul><li>Does s/he have the drive to see this business through? </li></ul></ul><ul><ul><li>Who is on the management team? </li></ul></ul><ul><ul><li>Will they be able to execute? </li></ul></ul><ul><li>Human capital attracts the financial capital </li></ul>
  10. 10. Characteristics of Successful Entrepreneurs <ul><li>Keenly Observant: about the needs of industries, markets, and everyday life and find the best way to meet these needs </li></ul><ul><li>Risk Taker: leave stable jobs and guaranteed salaries for their enterprises </li></ul><ul><li>Drive: enthusiasm spurs the drive of other employees </li></ul><ul><li>Flexibility: to adapt and react quickly to changes in environment </li></ul><ul><li>Vision: not driven by money, but by a vision or a passion consistently pursued </li></ul>
  11. 11. Entrepreneurial Balance <ul><li>Reconcile several paradoxes: </li></ul><ul><ul><li>visionary vs. being realistic: coming up with unique ideas that are grounded in reality </li></ul></ul><ul><ul><li>quick returns vs. investing in the future: build the organization while meeting the demands of the investors </li></ul></ul><ul><ul><li>optimism vs. pragmatism: evaluate potential weaknesses of the business </li></ul></ul>
  12. 12. The Idea <ul><li>Common types of business ideas: </li></ul><ul><ul><li>Introduce a new product (new software—MP3) </li></ul></ul><ul><ul><li>Introduce a new service (overnight delivery—FedEx) </li></ul></ul><ul><ul><li>Improve an existing model of business (selling books on the Internet— </li></ul></ul>
  13. 13. The Management Team <ul><li>Consists of individuals filling three roles: </li></ul><ul><ul><li>technology specialist: understands the specific mechanics of how the product works, how it is manufactured, and how it can be utilized </li></ul></ul><ul><ul><li>sales and marketing specialist: has an in-depth understanding of the customer </li></ul></ul><ul><ul><li>execution specialist: keeps everything in perspective making the vision a reality </li></ul></ul>
  14. 14. Strategic Advisors and Partners <ul><li>Provide the startup with strategic direction, advice, and credibility </li></ul><ul><ul><li>advisory board: an outsourced resource to fill a particular need - may receive stock options in exchange for expertise </li></ul></ul><ul><ul><li>board of directors: responsible for the well-being of the company, holding the management team accountable for its actions </li></ul></ul><ul><ul><li>strategic association: the agreement of two entities to work together and exchange expertise in areas where they lack core competencies </li></ul></ul><ul><ul><li>strategic alliance: a legally binding contractual agreement to share resources on a project for a particular timeframe </li></ul></ul>
  15. 15. Logistical Advisors and Partners <ul><li>Involved in the day-to-day business operations </li></ul><ul><ul><li>necessary logistical advisors and partners include certified public accountants (CPA) and legal counsel </li></ul></ul><ul><ul><li>supporting logistical advisors and partners are outsourced - may include intermediaries , consultants , and incubators </li></ul></ul>
  16. 16. Financial Capital <ul><li>Debt financing (commercial banks, trade credit) </li></ul><ul><li>Equity financing (bootstrapping, venture-capital) </li></ul><ul><li>Strategic investors: concerned with how a business compliments their current activities </li></ul><ul><li>Financial investors: concerned with return on investment (ROI), internal rate of return, cost of capital, and return on equity </li></ul>
  17. 17. Debt Financing <ul><li>Trade credit: extended to a business by its suppliers - interest-free loan from when supplies are delivered to when the invoice is due </li></ul><ul><ul><li>established track record of making prompt payments </li></ul></ul><ul><ul><li>hidden interest rate cost </li></ul></ul><ul><li>Commercial bank loan: installment loan for a specified period with either fixed or variable interest rate </li></ul><ul><ul><li>evaluate a business’ loan application by assessing the likelihood of loan repayment </li></ul></ul><ul><ul><li>relatively difficult to obtain, especially with no history, little collateral and no positive cash flow </li></ul></ul>
  18. 18. Equity Financing: Bootstrapping <ul><li>Using personal resources to finance the early stages of a startup </li></ul><ul><ul><li>may include personal loan, mortgaging a home, credit cards, savings accounts </li></ul></ul><ul><ul><li>provides the most viable option in the earliest stages of business, especially while proving the business concept </li></ul></ul><ul><ul><li>allows entrepreneur to control company and refine business strategy without pressure from investors </li></ul></ul><ul><ul><li>disadvantage of bootstrapping - unlikely to provide sufficient cash for quick growth </li></ul></ul>
  19. 19. Equity Financing: Venture Capital <ul><li>VC firms are usually private partnerships or closely held corporations that raise money from a group of private investors </li></ul><ul><ul><li>VC firms typically invest $250,000 to $10 million in a business in exchange for a 30 to 40 percent equity stake and a seat on the board of directors </li></ul></ul><ul><ul><li>startup receives cash and guidance </li></ul></ul><ul><ul><li>VCs typically charge management fees of 1 to 5 percent of the capital investment in a startup </li></ul></ul><ul><ul><li>VCs seek opportunities that will return 10 times the original investment within five years - realize that only 10 percent succeed </li></ul></ul><ul><ul><li>biggest disadvantage of venture capital funding is the source’s concern with the bottom line </li></ul></ul>
  20. 20. Venture Capital Investments—Breakdown by Stage $BB Source: Data from PricewaterhouseCoopers, MoneyTree Survey: Full Year & Q4 2001 Results: US Report .
  21. 21. Equity Financing: “Angels” <ul><li>Wealthy individuals who invest personal capital in startups in exchange for equity or a seat on the board of directors </li></ul><ul><ul><li>critical for entrepreneur to develop network of individuals within the industry because “angels” seldom look at unsolicited business plans </li></ul></ul><ul><ul><li>business plans evaluated based on the quality of the management team, market potential for the business idea, and track record of the entrepreneur </li></ul></ul><ul><ul><li>typically more flexible in accepting changes in the original business plan if required and reasonable </li></ul></ul><ul><ul><li>tend to get more involved in the day-to-day operations </li></ul></ul>
  22. 22. Equity Financing: Corporate Ventures <ul><li>Large corporations sometimes set up venture funds as a subsidiary to make investments on behalf of the parent company </li></ul><ul><ul><li>corporate-venture funds invest in complimentary business for strategic reasons </li></ul></ul><ul><ul><li>in exchange for cash, corporate ventures seek an equity stake in the company and access to the company’s technology or product </li></ul></ul><ul><ul><li>established corporations provide operational expertise, credibility and visibility </li></ul></ul><ul><ul><li>because investments are strategic rather than financial, pricing of deals with corporations tends to favor the entrepreneur more than deals with venture-capital firms </li></ul></ul>
  23. 23. The Business Plan <ul><li>A business plan provides the following information to a potential investor </li></ul><ul><ul><li>description of the product or service that will be offered and the value proposition for the customer </li></ul></ul><ul><ul><li>summary of the size and nature of the market opportunity </li></ul></ul><ul><ul><li>explanation of the revenue model </li></ul></ul><ul><ul><li>profiles of the management team, advisory board, and board of director members describing specific relevant skills and expertise </li></ul></ul><ul><ul><li>clear articulation of the startup’s core competencies and sustainable competitive advantage </li></ul></ul><ul><ul><li>summary of financials and financing needs </li></ul></ul>
  24. 24. Valuation <ul><li>Trying to determine the worth of a company </li></ul><ul><li>Methods used </li></ul><ul><ul><li>The Comparables Method </li></ul></ul><ul><ul><ul><li>compare firm to other similar companies </li></ul></ul></ul><ul><ul><ul><li>should be similar with respect to industry focus, income statement ratios, location, relations with suppliers, customer base, potential growth, growth rate and capital structure </li></ul></ul></ul><ul><ul><ul><li>assumes that similar companies exist and that the information for comparison is available </li></ul></ul></ul>
  25. 25. Valuation <ul><li>The Financial Performance Method </li></ul><ul><ul><li>Use company’s earnings (or potential earnings) to project future cash flows and applies a discount rate to determine the Present Value (PV) of those cash flows </li></ul></ul><ul><ul><li>The Discounted Cash Flow (DCF) is determined from </li></ul></ul><ul><ul><ul><li>Proforma Income Statements – projections about the company’s future income statements based on growth assumptions for cost and revenues </li></ul></ul></ul><ul><ul><ul><li>Free Cash Flow – estimated amount of cash company will have available based on the proforma income statement </li></ul></ul></ul><ul><ul><ul><li>Terminal Value – expected value of the company at the end of the projected period - discount rate is then applied to this value to estimate the present value of the company </li></ul></ul></ul>
  26. 26. Valuation <ul><li>The Venture Capital Method </li></ul><ul><ul><li>use a hybrid valuation method, looking at both comparables and free cash flows </li></ul></ul><ul><ul><li>to compensate for their high risk investments, VC’s apply a very large discount rate to estimate the company’s present value </li></ul></ul><ul><ul><li>to compensate for future dilution, VC’s require a higher percentage ownership </li></ul></ul><ul><ul><li>this valuation method is necessarily subjective </li></ul></ul>
  27. 27. Typical Discount Rates by Funding Stage Source: Data from James L. Plummer, QED Report on Venture Capital Financial Analysis (QED Research, Palo Alto, CA), 1987 25%-35% IPO 30% to 40% Fourth Stage 30% to 50% Third Stage 35% to 50% Second Stage 40% to 60% First Stage 50% to 70% Startup
  28. 28. Negotiations <ul><li>Principles for Entrepreneurs </li></ul><ul><ul><li>investors want to know two things: What is the opportunity and why is this management team the best to pull it off </li></ul></ul><ul><ul><li>guidelines for pitching an investment opportunity </li></ul></ul><ul><ul><ul><li>know the audience </li></ul></ul></ul><ul><ul><ul><li>keep the presentation concise </li></ul></ul></ul><ul><ul><ul><li>talk about the management team </li></ul></ul></ul><ul><li>Term Sheet </li></ul><ul><ul><li>a non-binding description of the proposed deal between the financier and the entrepreneur </li></ul></ul><ul><ul><li>analogous to a Letter of Intent (LOI) or Memorandum of Understanding (MOU) </li></ul></ul>
  29. 29. Negotiations <ul><li>Securities </li></ul><ul><ul><li>type of securities chosen by company and the investor reflect the risk/reward appetite </li></ul></ul><ul><ul><ul><li>Zero Coupon Bonds - upon maturity the investor redeems the initial investment and interest at a predetermined rate -provides ultimate protection to the investor </li></ul></ul></ul><ul><ul><ul><li>Convertible Debentures – loans that are ‘converted’ into common stock (equity) - investor is considered to be a creditor until the company is past its high-risk stage </li></ul></ul></ul><ul><ul><ul><li>Preferred Stock – most commonly used security with VCs </li></ul></ul></ul><ul><ul><ul><ul><li>Convertible Preferred </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Redeemable Preferred </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Participating Convertible Preferred </li></ul></ul></ul></ul>
  30. 30. Negotiations <ul><li>Rights and Privileges of Investors </li></ul><ul><ul><li>Common rights that investors demand are </li></ul></ul><ul><ul><ul><li>Right of First Refusal – Investor has the right to meet any offer of outside financing in future investment rounds </li></ul></ul></ul><ul><ul><ul><li>Preemptive Right – Investor has the right to maintain his percentage of ownership by investing additional funds in future investment rounds </li></ul></ul></ul><ul><ul><ul><li>Redemption Rights – Investor has the right to achieve liquidity if the company has not been sold or undergone IPO within a predetermined time period </li></ul></ul></ul><ul><ul><ul><li>Registration Rights – Investor has the right to demand that shares be registered, forcing the company into liquidity (public offering) </li></ul></ul></ul><ul><ul><ul><li>Covenants – Terms designed to ensure that the money provided by the investor is used in a manner that is consistent with the agreement between the entrepreneur and investor </li></ul></ul></ul><ul><ul><ul><li>Antidilution Provisions – Provisions that protect the investor from dilution in ownership that might occur in future round of financing </li></ul></ul></ul>
  31. 31. Pre- and Post-Money Valuations       Cumulative   Round of Financing Amount invested this round % Received this round VC’s Share Founder’s Share Implied Valuation (Post Money) Seed-stage Round $1,000,000 40% 40% 60% $2,500,000 First Round $4,000,000 20% 52% 48% $20,000,000 Second Round $15,000,000 20% 62% 38% $75,000,000
  32. 32. Venture-Backed IPOs: 1995-2001 Number of IPOs Source: Data from VentureOne research.
  33. 33. Exit: Firm Liquidity <ul><li>Initial Public Offering (IPO) </li></ul><ul><ul><li>Determining the Right Time for an IPO </li></ul></ul><ul><ul><ul><li>Asses if the company is ready for an IPO </li></ul></ul></ul><ul><ul><ul><li>Asses if the market is ready to accept their offering </li></ul></ul></ul><ul><ul><li>The IPO Process </li></ul></ul><ul><ul><ul><li>Selection of Underwriters – The underwriters are the bankers that will arrange for the purchase of stock for a commission </li></ul></ul></ul><ul><ul><ul><li>Preparation of Registration Statement for SEC – Create prospectus outlining company’s business and financial fundamentals </li></ul></ul></ul><ul><ul><ul><li>Distribution of Preliminary Prospectus - or ‘Red Herring’ </li></ul></ul></ul><ul><ul><ul><li>Preparation for and Completion of the Road Show – The company’s offering is presented directly to potential investors </li></ul></ul></ul><ul><ul><ul><li>The Incorporation of SEC comments into the Registration Segment </li></ul></ul></ul><ul><ul><ul><li>Agreement on a final share price and number of shares to be offered </li></ul></ul></ul><ul><ul><ul><li>Close of the offering and distribution of the final prospectus </li></ul></ul></ul>
  34. 34. IPO Pros and Cons Pro Con Provides founders and shareholders with liquidity (although not immediate liquidity because of lock out periods, signals to the market, etc.) IPOs are expensive and time-consuming. An unfavorable market (something that the company can not control or predict) might necessitate pulling the IPO at the last second Provides capital to fuel expansion and growth within the company Strict SEC reporting requirements Possibility of attracting and retaining employees at lower than market rates because of granting of stock options and promise of eventual liquidity Pressure to product quarterly numbers for analysts The price of the company’s shares should increase dramatically with an IPO, providing (at least paper) wealth to the founders and other shareholders Increased Officer and Director liability As long as the company is performing well, it can return to the market to raise additional cash Hostile takeover is possible The ability to use stock as currency Doesn’t necessarily provide a liquid market for all shareholders because of restrictions on trading the stock
  35. 35. Exit: Firm Liquidity <ul><li>Mergers and Acquisitions (M&A) </li></ul><ul><ul><li>M&A can often achieve the same goals as IPO (e.g. liquidity and increased valuation) with lower potential risk </li></ul></ul><ul><ul><li>In a Merger, two companies combine to achieve a financial and/or strategic objective, usually through the exchange of shares </li></ul></ul><ul><ul><li>In an Acquisition, one company buys another, usually with cash and/or stock </li></ul></ul><ul><ul><li>Analysts predict that M&A will become increasingly popular </li></ul></ul>