Tse sources of_capital_2014 (1)

The Smart Entrepreneur
Sources of Capital

Sources of Finance
• Internal Finance
» Cash Flow from sales
» Reinvested profits
• External Finance
» Debt
» Equity
» Strategic partners
» Subsidies
Copyright of Bart Clarysse and Sabrina Kiefer

External Sources of Finance
• Subsidies and other government measures
• Debt
» Bank Loans
» Leasing
• Equity
» Business Angels
» Venture Capital
• Strategic partners
» R&D and product co-development
» Joint venture

Equity investors
• Angel investors
» Wealthy private investors, often experienced entrepreneurs
» There are approximately 18,000 active angels in the UK and >200,000 in the
USA
» British Business Angels Association http//:www.bbaa.org.uk
• Venture Capital firms
» Professional equity investment that is co-invested with the entrepreneur to
finance a company in an early stage or expansion phase
» Venture capital fund:
• The vehicle of pooled money through which joint investments by several
investors can be made
• A VC fund’s investors may be large institutions such as pension funds or high
net worth individuals – these are known as ‘Limited Partners’ or LPs

Venture Capital – particular kinds of VC funds
• Captives
» Invest capital raised from a single parent organisation that is often a bank
or insurance company – different from a fund with many LPs
» Are strategic investors (do not only look at return on investment, but also
consider return from other activities, such as loans that can be sold by
the bank
• Public funds
» Often called ‘micro-funds’
» Usually small and co-invest alongside private investors
• Funds may also differ with respect to:
» Size
» Specialisation or diversification in terms of
 Investment phase (early stage, late stage)
 Business Sector

Venture Capital Funds (cntnd)
corporate investors 5%
private individuals 3%
government agencies 7%
banks 22%
pension funds 19%
capital markets 0%
academic institutions 2%
fund of funds 16%
not available 17%
insurance companies 9%
Europe
Source: EVCA (2004)

Venture Capital (cntd)
Europe 2,1 billion Euro
amounts invested by stage
14.405.952 10.944.574
16.920.576 18.423.246
13.916.398
9.202.988
7.796.736
8.533.380
6.663.403 4.183.799
2.930.688 2.139.293
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2000 2001 2002 2003
year
early phase
expansion/replacem
buyout
Source: EVCA (2004) Copyright of Bart Clarysse and Sabrina Kiefer

Why think about your funding strategy?
It is important to understand what kind of funding is most appropriate
for your venture.
Many aspiring entrepreneurs automatically think ‘VC’, but this is the
most expensive form of capital and not the first usually raised –
you have to jump through a few hoops before you can raise formal
VC.
Normally you will have to start with a bit of your own money, friends’ or
relative’s money, or ‘soft’ public money for some early development
and to remove some risk for investors.
Can you reach the point of making sales without outside equity
investors? Then you might consider loan funding instead of equity.

How to seek external funding
The type of external finance you can obtain will depend upon
• Your venture’s stage of development
• Complexity of your project

Stage of Venture Development and Funding
Initial Ideas Feasibility Prototyping Commercialisation
Own cash; ‘friends, family & fools’
Grants (Govt., EC etc)
Bank Loan
Business Angels
Venture Capital
Consultancy or other earned income to live on
Real Sales!
Strategic Partners

Complexity of the project
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Profile analysis for differences between companies with a technology complexity above and below average in regard
Personal savings Bank loan based on
personal collateral
Loans from
family/friends
to sources of start-up capital
Business angels Venture capital Government loan
Complexity above average Complexity below average
Bollingtoft et al. (2003)
Source: abetcredit.com

1. Planning your funding strategy: Key Questions
A. The ‘type’ of business you are starting affects the type of
financial capital you can access
B. The rate at which your business will consume cash (the Burn
Rate) and whether/when you are likely to run out of cash
C. Your attitude towards growth and to sharing ownership and
control
D. What ‘stage of development’ your business is at
E. The risks involved and the returns expected by financiers
F. Your bargaining power relative to the providers of capital

A & B: Type of business and cash burn
Bank
balance
£
+
0
-
Technology firm
•Large investment
required
•Long development time
to get sales cash burn
•Late cash break-even
•Huge upside (Microsoft)
• Attracts high risk/reward
investor
Consulting firm
•Low investment
required
•Shorter lead time to
sales
•Early cash break-even
•Modest upside
•Attracts lower
risk/reward finance
Time

Your bargaining power
Depends on:
• How much money you need (compared to how much you already have)
• How soon/urgently you need it
• How much risk your investor is taking
» How protectable is your business
» How much certainty of getting to market
» How much customer/sales interest, contacts, ‘complementary assets’ you
already have
• How many other investors are interested in your business
» And the current investment environment

Rules of Thumb
Limit your need for expensive external finance
• Bootstrapping – founders self-finance, plus family & friends (‘the
3Fs’)
» Leasing instead of buying
» Customer funded R&D
» Upfront payment from customers for product development
» Working from home
• Limit as far as possible your need for net working capital –
» Limit Expenses
» Timing of cash flows (see ‘Financial Plan’ tools in IE&D Toolbox)
» Least amount of inventory you can hold
• Use subsidies where possible, e.g. for
» Prototyping
» Feasibility studies

Selling your proposal to an investor
similar to selling your product...
• The investor’s perspective:
» Understand what your client/investor expects (e.g. ROI - Return on
Investment)
» understand how he reasons
• The entrepreneur’s perspective:
Pursue your own due diligence
» What strengths does your plan have? What weaknesses does it have? What
kind of business do you want to build?
• Does it have an impact on the investor you can attract?
• Does it have an impact on the investor you want to attract? (value-adding)
• Make use of the first chance, it is unlikely that there will be a second

Government measures
Country- and region-dependent... and change when governments change!
• 7 types of measures – UK examples
» Capital Grants, Also known as ‘soft money’, e.g
• See j4bgrants (link) or search on Google
» Substitution - 100% public fund---e.g.: NESTA Investments
» Co-investment - government invests in a managed fund alongside a private partner,
e.g. NESTA Capital, University Challenge Seed Funds
» Risk Sharing, e.g. -- Regional Venture Capital Funds - public funds that co-invest in a
company alongside a private investor, f.i. London Technology Fund
» Fiscal measures – provide tax breaks to people or companies investing through the following
schemes:
• Venture Capital Trusts – a publicly quoted VC fund with tax breaks for its investors
• Enterprise Investment Schemes – a tax-friendly investment in a qualifying start-up company
• Corporate Venturing Scheme – tax advantages for corporations forming partnerships with
entrepreneurs
• R&D Tax Credits – makes doing R&D cheaper for companies
» Incubation structures - see UKTI (link)
» Loans and loan guarantees
• Enterprise Finance Guarantee Scheme (link)

Debt: The ‘five Cs’ of obtaining a bank loan
Banks look for:
• Cash flow – do you have any yet? (Are you making sales,
consulting?)
• Collateral: What assets do you have to secure the loan? The bank
may ask you to secure the loan against your personal assets if the
company doesn’t have enough.
• Capital: What cash do already have in the company?
• Character: What is your business experience? How have you
managed other loans (business and personal)?
• Conditions: your economic and industry environment

Main measures banks use to assess borrower solvency/risk
Debt ratio and coverage ratio
• Total debt ratio (%)
Debt
= *100
TotalEquityandLiabilities
• Coverage of total debt
CFaftertaxes
= *100
TotalDebt
• Coverage of LT debt payable < 1yr by CF
CFaftertaxes
Debt >1 yr ,
payable within theyear
=
The higher the ratio, the higher the
financial risk
Can all debts be paid back with only
one year’s cash flow?

Debt: Leasing your equipment
Leasing equipment instead of buying it can be a way to secure
debt and spread your cash burn over time:
• A leasing company (the lessor) buys the equipment and leases it to you
over the useful life of the equipment
• The equipment serves as collateral on the debt
• However, you pay interest to the lessor as well as repaying principal cost
of the equipment

Equity investors: Business Angels
• Objectives : fun and return
• Often experienced entrepreneurs, so usually want hands-on
involvement in a sector that they understand
• £10-£250k is a typical angel investment (some angels and angel
syndicates may do more – up to £1m in a syndicate)
• Use their friends and networks to spot opportunities

Business Angels (cntd)
Expectations and Targets
• Financial return: 30-35% per year
• They only invest if
» there is a “match” with the entrepreneur
 Condition is that the entrepreneur accepts
the business angel’s involvement
• They are familiar with the sector the
company is in
• Invest at an early stage, at the moment that
most VCs are reluctant to invest
• They consider themselves part of the
entrepreneurial team – provide mentoring
and contacts
Doug Richard

Equity investors: Venture capital
Venture capital funds are answerable to their own investors
• Therefore, they require a higher return than Angels, in order to make
money for themselves as fund managers and a return for the providers of
capital – the Limited Partners
• They also invest higher sums than Angels, >£1m, but at a later stage
• They like to blog! More than angels do! (Not enough work to do?)
(VC blog directory)
Fred Wilson – ‘a VC’ blog Biotech
http://lifescivc.com/ blog
Mark Suster blog

What VCs do
VCs think in milestones…and dream of EXITS
“Nobody makes real money until the exit”

What VCs do with a 10-year fund
Build an investment base (raise
finance from co-investors)
Build a management team
Selection and due diligence of
investment projects
Follow-up on investments, monitoring
Exit investments

What deals do VCs look for?
• Clean IP portfolio - Especially in early stage tech firms
• Sector - Investors back what they know (so check out their
portfolio). They also learn from their mistakes.
• Financial indicators - Gross margin is a favourite – must
be very high!
• Entry valuation - typically 30% less than an equivalent
quoted company (a black art…)
• Exit route - can I get out? When? How much will it be
worth? (also a black art..)
• Due diligence - any skeletons?
• The team - especially positive if they have worked
together successfully before

Investment return (dependent on phase)
Expected yearly return
Belgium and NL UK France USA
(n=38) (n=66) (n=32) (n=73)
general 15% 30% 25% 30%
seed and start-up 31-35% 46-55% 36-45% 46-55%
growth/expansion 21-25% 31-35% 21-25% 31-35%
buy-out 21-25% 31-35% 26-30% 26-30%
Source: Manigart et al. (2002)
What does this mean in practice?

35% 55%
Investment return
Investment 100 100
After 1 year 135 155
After 2 years 182 240
Required return Multiple = 6 Required return Multiple = 13,9

Follow-up on the investment
Large differences between VC funds
• Hands-on vs. Hands-off
• Control vs. Value-adding
» Opening of the financial/commercial network to the portfolio
company
» Negotiation of important contracts
» Hire executives
• Captives and public funds are often more hands-off
• Specialized funds are mostly hands-on

Exit
• IPO
» Chances are limited, esp. in Europe (<5%)
• Trade sale
• Sale to another financial investor (e.g. later-stage investor)
• Management buy-out
• Bankrupcy/ Liquidation

What are your chances of getting VC funding?
0 20 40 60 80 100
250 hours….
Plans submitted
After quick scan
After few hours study
After full investigation
After price negotiations
 3.1 minutes
% Remaining
2.0%
© Simon Stockley Copyright of Bart Clarysse and Sabrina Kiefer

If you get VC financing : what is expected of you?
Example: VC invests 2 mio Euro, in return for 40% of shares
50% return per year
Value of the investment after 5 y: 2 * 7,6 = 15,2 mio Euro
Participation = 40%
Value of the company after 5 y: 15,2 / 0,4= 38 mio Euro
P/S = 0,5
Sales (S) after 5 y: 38 / 0,5= 76 mio Euro
Market share = 25%
Market size after 5 y: 76 / 0,25 = 304 mio Euro

Differences between business angels and VCs
Business Angel VC fund
Invest own means Invests someone else's funds
Goal: 1) fun, 2) return Goal: return
Somewhat lower return on investment Higher return on investment
Faster decision process Slower decision process
Invests in a very early stage Invests in a later stage
Less sophisticated contracts Very sophisticated contracts
Large involvement Lower involvement (fund dependent)
Longer investment horizon Shorter investment horizon
Lower legitimacy Higher legitimacy
Source: Manigart and Meuleman (2005)

Strategic Partnerships
• Co-operation at R&D level, joint venture, product co-development
• Partner may take part in the start-up’s shareholder capital
» e.g.: biotech company with pharmaceutical company as shareholder
» Why? Window on technology
» Caveat! Restricts your exit possibilities (trade sale to competing companies is
unlikely)
» A strategic partner may also see the partnership as a way to boost sales of its
own products – this may not always benefit the entrepreneurial start-up
• Corporate venturing examples in Europe:
» BP AI, Bosch VC, Cisco Investments, SUN CV

Example of funding by stages: Amazon.com
PPrriiccee//SShhaarree (($$)) TTiimmee LLiinnee SSoouurrccee ooff ffuunnddiinngg
Jul ‘94
Feb ‘95
Aug ‘95
Dec ‘95
May ‘96
Jun ‘96
May ‘97
Dec ‘97
0.001
0.1717
0.3333
0.3333
0.3333
2.3417
18
52.11
Founder: $10K + loan of $44K
Family: $245.5K
Business Angel: $54.4K
BA syndicate: $937K
Family: $20K
VC: $8M
IPO: $49.1M
Loan: $75M
Bond issue: $326M

Conclusion
• Limit your need for external finance where possible
• Plan and seek the right type of finance for your current stage of
development
• Understand your investor’s requirements when selling your
proposition
• Use soft money (grants) where possible
‘Never buy new what can be bought second-hand
Never buy what can be rented
Never rent what can be borrowed
Never borrow what can be begged
Never beg what can be salvaged’
- Prof. Ian MacMillan, Wharton

Further reading
Clarysse, B. and Kiefer, S., 2011. The Smart Entrepreneur. London:
Elliot & Thompson, Ch. 11.
Acland, S., 2001. Angels, Dragons and Vultures: How to tame your
investors... and not lose your company. London: Nicholas Brealy
Publishing.
Berkery, D., 2008. Raising Venture Capital for the Serious
Entrepreneur. New York: McGraw Hill.

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