Capital_ Valuation_ and Exit Strategies

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CHAPTER 9

             CAPITAL, VALUATION, AND EXIT
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STRATEGIES
LEARNING OBJECTIVES

After completing this chapter, students should be able to:

   Identify the various sources of capital available to the entrepreneur.
   Determine which sources of capital are better under different situations.
   Explain the major differences between debt and equity capital.
   Describe the various SEC regulations and their effects on the raising of capital.
   Discuss how to arrive at a reasonable valuation of a venture.
   Explain the importance of an exit strategy to the fund-raising function.


9-1 INTRODUCTION

The entrepreneurial venture requires cash to operate and grow. In the early stages, most ventures
don’t generate sufficient capital from sales to sustain themselves.

   In fact, many new ventures don’t have any sales for a period of time while they are
    developing products and services, protecting intellectual property, and crafting effective sales
    and marketing strategy.
   During these early stages, new ventures require capital from other sources to survive.
   Many entrepreneurs will readily admit that one of their most important jobs is raising money.

    o Because of this potential for chance encounters with potential investors, the entrepreneur
      should be armed with a well-rehearsed elevator speech so as to not miss the opportunity
      to attract the potential investor.
    o The elevator speech is just one of the important skills that the entrepreneur must possess
      to be a successful fund-raiser.
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Chapter 9: Capital, Valuation, and Exit Strategies                                         9-2



   The various sources of funds for the entrepreneurial venture and a variety of skills that
    entrepreneurs need to secure funds from those sources.

    o     In order to raise funds, entrepreneurs must be able to provide answers to two critical
         questions:

             What is the value of the venture?
             What is the exit strategy?

              1. Venture valuation can be calculated using several techniques. Depending on the
                 sophistication of the funding source, the entrepreneur may need to use one or
                 another of the techniques.
              2. The second question deals with the pathway that the entrepreneur intends to
                 follow to turn invested capital into cash and provide a return to the investors.
                 There are a number of exit strategies that an entrepreneur can elect to use. One of
                 the most common exit strategies is to sell the venture to a larger company.

9-2 SOURCES OF CAPITAL

The two major sources of funds for a business are debt capital and equity capital.

   Debt capital: Funds obtained through borrowing.
   Equity capital: Does not require repayment.

    o These funds come from the current owners of the firm or from outsiders who provide
      capital in exchange for some ownership in the firm.
    o Sources of equity capital include retained earnings, or earnings that the owners do not
      pay to themselves but rather leave in the firm as an additional investment; additional
      contributions of the owners, that is,

             Additional money from the owners' personal sources; investments by outsiders in a
              privately owned firm, by adding new partners to bring in new capital; and stock
              issues to the general public, or stock sold to the public for capital.

    o Debt capital is categorized into two types:

             Short term
             Long term

9-2a     Short-Term Debt Financing

Short-term debt is used to finance current operations, with required payback within one year.
Short-term financing can come from several different sources:
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-3




Friends and Family

When funds are needed for only a short time, friends and family often help the entrepreneur with
a loan.

   Such borrowed funds bring an extra risk; if things do not work out and the business goes
    sour, the friend or the family relationship may be lost.
   Money borrowed from family or friends should be handled like any other loan.

Commercial Banks

Turning to commercial banks as an alternative source of short-term funds and generally makes
more sense than turning to relatives or friends.

   The commercial banker can better help with any cash flow problems and can give sound
    advice.
   Developing a close relationship with a local banker is a good idea.

    o This will pay off in the long run because the banker will pay closer attention to the new
      business and alert the entrepreneur to potential problems.
    o Also, when an entrepreneur needs emergency funds, the banker will be more willing to
      help out because the two have developed a trusting relationship.
    o Statistics from the U.S. Small Business Administration indicate that commercial banks
      lent out over $129 billion in so-called business micro-loans in the 2002 reporting period.
      A micro-loan is defined as a loan under $100,000.

   Bank loans come in many different forms.

    o Unsecured loans are loans based solely on the good credit of the borrower.

             They require no collateral.
             Banks will require some form of collateral to guarantee the loan.

    o Secured loans are backed by collateral, which is usually something of equal or near equal
      value to the loan amount.

             The collateral reduces the risk for the banker.
             If the borrower fails to repay the loan, the lender may take possession of the
              collateral.
             Types of collateral include a business’s property, equipment, inventory, or accounts
              receivable.
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              1. Using accounts receivable as collateral for a loan is called pledging. The cash
                 received for the accounts receivable goes to the banker instead of being retained
                 in the company.

    o A borrower who has a good relationship with the bank may be able to open a line of
      credit.

             The bank pre-approves the borrower for a specified amount of credit, usually
              unsecured.
             The borrower may borrow up to that amount without having to apply for a loan each
              time funds are needed.
             As the entrepreneur’s credit record with the bank lengthens and the business matures,
              this line of credit is often increased.

    o A revolving credit agreement guarantees that the bank will honor a line of credit up to the
      stated amount.

             A revolving credit agreement generally requires payment of a fee.

    o A relatively expensive form of short-term credit is factoring.

             A firm actually sells the accounts receivable to the factoring companyat a discount.
             Firms do not generally like to use factoring; it is expensive and sends a message to
              suppliers and creditors that the company may be in financial trouble.

    o Floor planning is another option in bank financing.

             In some industries, such as automobiles and major appliances, borrowers will assign
              the title to their inventory to the bank as collateral for short-term loans.
             As the inventory is sold, borrowers pay off the loan, plus interest, to the lender.

Trade Credit

Another widely used source of short-term financing for entrepreneurs is trade credit.

   Trade credit is credit given to a firm by the trade; the buyer can take a 2 percent discount if
    the invoice is paid within ten days; if the discount is not taken, the full bill is due in thirty
    days
   The entrepreneur may want to use such terms to encourage clients to pay their bills in a
    timely manner.

Credit Cards
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Many new ventures are too small for banks to consider as candidates for credit. In such cases,
some entrepreneurs rely on credit cards to help finance the early stages of their ventures.

   Using credit cards to finance a business can lead to problems if the cards are utilized without
    fiscal discipline.
   However, there are many advantages to using credit cards that entrepreneurs need to keep in
    mind.

    o    The ease with which they can be obtained.
    o    They are nearly universally accepted.
    o    They are very convenient to use.
    o    They will assist the entrepreneur in financial record keeping via monthly statements.
    o    After the business has been operating for a while and has been reliably using the card and
         paying, many credit card companies will extend the spending limit for the entrepreneur.

   The most prominent disadvantage of a credit card is the relatively high rate of interest that
    must be paid on amounts borrowed.

Internal Funds Management

Whenever possible, a venture should attempt to obtain its needed funds from internal sources.

   A close review of the balance sheet and accounting ratios will reveal possible sources of
    funds that have been overlooked.
   Entrepreneurs should work hand-in-hand with their accountant to ensure that funds are not
    tied up in noncash assets.

9-2b     Long-Term Debt Financing

A venture should plan for long-term capital; successful companies constantly refocus on their
long-term goals and objectives.

   If the venture has an objective to maintain a certain level of growth, it must provide the funds
    to pay for that growth.
   If a company knows its objectives, it needs to look at possible sources of long-term capital to
    help it accomplish those objectives.

Term Loans

Most term loans have three- to seven-year terms, though some may extend to fifteen or twenty
years.
Chapter 9: Capital, Valuation, and Exit Strategies                                         9-6


   The business is required to sign a term loan agreement. This agreement is a promissory
    note, which requires the borrower to repay the loan according to a schedule of specified
    installments at a rate of interest that is either fixed or flexible.
   Most long-term loans require some form of collateral, such as real estate, machinery,
    equipment, or stock.
   When determining the interest rate for such loans, the bank looks at the length of time the
    loan is for, the type of collateral, the firm's credit rating, and the general level of market
    interest.

SBA Loans

Long-term debt financing can often be used once a firm has established a rapport with a bank or
other financial institution, such as an insurance company or pension fund.

   For a smaller business, the U.S. Small Business Administration (SBA) can often be a good
    source of loans.

    o The SBA, by guaranteeing major portions of loans, enables its lending partners to provide
      financing to small businesses when funding is otherwise unavailable on reasonable terms.
    o The agency does not have funding for direct loans, nor does it provide grants or low-
      interest loans for business start-up or expansion.
    o The eligibility requirements and credit criteria of the program are very broad in order to
      accommodate a wide range of financing needs. To qualify for an SBA guaranty, a small
      business must meet the SBA’s criteria, and the lender must certify that it could not
      provide funding on reasonable terms without an SBA guaranty.
    o Most cases, the maximum guaranty are $1 million. There are higher loan limits for
      international trade, defense-dependent small firms affected by defense reductions and for
      certified development company loans.

Leverage

The use of long-term debt to raise needed cash is sometimes referred to as leverage. The
borrowed cash acts like a lever to increase the purchasing power of the owner’s investment.

   Leverage works to maintain higher rates of return on owners' investments and allows the
    owners to create a larger firm for the same investment.

    o As long as earnings exceed interest payments on the borrowed funds, the firm should be
      all right.
    o However, leverage also means a continued obligation to service the debt, and any
      significant downturn in sales could threaten survival.
    o The ability to generate additional cash through debt would be limited, leaving few outside
      sources of funds.
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-7



    o The required interest payments would represent a larger percentage of total sales. Current
      creditors and suppliers may become worried if the balance sheet does not look healthy.
    o Suppliers may demand cash payments for merchandise, increasing the size of any cash
      flow shortages.
    o The judicious use of leverage can help increase owners' returns, but too much debt can
      create massive problems for a company.

9-2c     Equity Capital

The term equity capital refers to funds invested by the owners of the venture. These funds can
be contributed by current owners or by outsiders who receive some share of ownership in the
company in return for their new investment. The five forms of equity capital are:

Retained Earnings

   Retained earnings are profits the owners have chosen to leave in the company rather than pay
    out in the form of dividends to shareholders.
   This method of financing growth limits the amount of cash that will be available and may
    cause long delays before expansion can occur.

Contributions

   The current owners of the firm can increase their contributions to the firm; the funds of
    current owners are often limited, which means slower growth.
   Outside investors may have more funds to spend, but they may demand some control over
    the operations of the company.

Sale of Partnerships

   If the current owners of the firm do not have extra funds to contribute to the firm, additional
    partners can be sought.
   The additional partners contribute funds to the firm and in return receive a share of the
    ownership.

Venture Capital

   Venture capitalists provide funds for a firm, provided they see potential for rapid growth, and
    in exchange receive a share of the ownership and frequently a share of control.

Public Sale of Stock
Chapter 9: Capital, Valuation, and Exit Strategies                                         9-8

As a company grows, its need for funds also grows. Then the owners have to consider selling
shares of ownership in their company.

   As evidence of ownership, a shareholder receives a stock certificate. Each certificate shows
    the name of the shareholder, the number of shares of stock owned, and the special
    characteristics of the stock.
   After making a request to the secretary of state of the state in which incorporation is sought
    (in some states, to the attorney general), the original incorporators and the board of directors
    of the corporation set a maximum number of shares into which the company can be divided.
   The shares sold are called issued stock, and unsold shares are unissued stock.

    o When a company sells stock, it gives a portion of the ownership of the firm to outsiders.
    o Each shareholder has a number of votes equal to the number of shares owned and uses
      these votes to elect the members to the board of directors.
    o Shareholders may also vote on mergers, acquisitions, and takeovers.

   The company also may pay dividends to shareholders.

    o Dividends are a distributed portion of the firm's earnings.
    o Selling stock to the public requires the venture to be alert to various regulations regarding
      disclosure of venture information, the size of the offering, and to whom the offering can
      be communicated.

9-3 TYPES OF STOCK OFFERINGS

In the chaotic securities markets of the 1920s, companies often sold stocks and bonds on the
basis of promises of fantastic profits, without disclosing meaningful information to investors.

   These conditions contributed to the stock market crash of 1929 and the ensuing Great
    Depression.
   In response, the U.S. Congress enacted the federal securities laws and created the Securities
    and Exchange Commission (SEC) to administer them.
   Entrepreneurs seeking to raise money for their venture through a sale of stock are subject to
    certain restrictions regarding the size of the offering, the type of individuals that can be
    approached, and the disclosures that are required to be made regarding the status of the
    company.

9-3a     Intrastate Offering Exemption

Section 3(a)(11) of the Securities Act of 1933 is generally known as the intrastate offering
exemption.
Chapter 9: Capital, Valuation, and Exit Strategies                                         9-9



   This exemption facilitates the financing of local business operations. To qualify for the
    intrastate offering exemption, a company must:

    o Be incorporated in the state in which it is offering the securities
    o Carry out a significant amount of its business in that state
    o Make offers and sales only to residents of that state

   There is no fixed limit on the size of the offering or the number of purchasers, but the
    company must determine the residence of each purchaser.

    o If any of the securities are offered or sold to even one out-of-state person, the exemption
      may be lost.
    o If a purchaser resells any of the securities to a person who resides outside the state within
      a short period of time after the company’s offering is complete, the entire transaction,
      including the original sale, might violate the Securities Act.
    o It is difficult for a company to rely on the intrastate offering exemption unless the
      entrepreneur knows the purchasers and the sale are directly negotiated with them.
    o If the company holds some of its assets outside the state or derives a substantial portion
      of its revenues outside the state in which it proposes to offer its securities, it will probably
      have a difficult time qualifying for the exemption.

9-3b     Private Offering Exemption

Section 4(2) of the Securities Act exempts from registration “transactions by an issuer not
involving any public offering.”

   To qualify for this exemption, the purchasers of the securities must:

    o Have enough knowledge and experience in finance and business matters to evaluate the
      risks and merits of the investment or be able to bear the investment’s economic risk.
    o Have access to the type of information normally provided in a prospectus.
    o Agree not to resell or distribute the securities to the public.

   The company originating the offering may not use any form of public solicitation or general
    advertising in connection with the offering.
   The precise limits of this private offering exemption are uncertain.
   If a venture offers securities to even one person who does not meet the necessary conditions,
    the entire offering may be in violation of the Securities Act.

9-3c     Regulation A Offerings
Chapter 9: Capital, Valuation, and Exit Strategies                                      9-10

Section 3(b) of the Securities Act authorizes the SEC to exempt from registration small securities
offerings.

   By this authority, the SEC created Regulation A, an exemption for public offerings not
    exceeding $5 million in any twelve-month period.
   Regulation A, offerings share many characteristics with registered offerings.

    o The offering venture must provide investors with a private placement memorandum
      (PPM).
    o Like registered offerings, the securities can be offered publicly and are not restricted,
      meaning they are freely tradable in the secondary market after the offering.
    o The principal advantages of Regulation A offerings, as opposed to full registration, are:

             The financial statements are simpler and don't need to be audited.
             There are no Exchange Act reporting obligations after the offering unless the
              company has more than $10 million in total assets and more than 500 shareholders.
             Companies may choose among three formats to prepare the offering circular, one of
              which is a simplified question-and-answer document.
             Companies may "test the waters" to determine if there is adequate interest in their
              securities before going through the expense of filing with the SEC.

   All types of companies that do not report under the Exchange Act may use Regulation A,
    except blank check companies, those with an unspecified business, and investment
    companies registered or required to be registered under the Investment Company Act of
    1940.

9-3d     Regulation D Offerings

Regulation D establishes three exemptions from Securities Act registration. Let's address each
one separately.

Rule 504

   Rule 504 provides an exemption for the offer and sale of up to $1 million of securities in a
    twelve-month period.
   A company may use this exemption so long as it is not a blank check company and is not
    subject to Exchange Act reporting requirements.
   Like the other Regulation D exemptions, in general the company may not use public
    solicitation or advertising to market the securities, and purchasers receive restricted
    securities.

    o However, the company can use this exemption for a public offering of securities, and
      investors will receive freely tradable securities under one of the following circumstances:
Chapter 9: Capital, Valuation, and Exit Strategies                                          9-11




             The company registers the offering exclusively in one or more states that require a
              publicly filed registration statement and delivery of a substantive disclosure document
              to investors.
             The company registers and sells in a state that requires registration and disclosure
              delivery and also sells in a state without those requirements, so long as it delivers to
              all purchasers the disclosure documents mandated by the state in which it registered.
             The company sells exclusively according to state law exemptions that permit general
              solicitation and advertising, so long as it sells only to accredited investors.

Rule 505

   Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in
    any twelve-month period.
   Under this exemption, a company may sell to an unlimited number of accredited investors
    and up to thirty-five other persons who do not need to satisfy the sophistication or wealth
    standards associated with other exemptions.
   The issued securities are restricted; purchasers must buy for investment only and not for
    resale. Consequently, the offering company must inform investors that they may not sell for
    at least a year without registering the transaction.
   The company may not use general solicitation or advertising to sell the securities.

    o An accredited investor is defined as one of the following:

             A bank, insurance company, registered investment company, business development
              company, or small business investment company.
             An employee benefit plan, within the meaning of the Employee Retirement Income
              Security Act, if a bank, insurance company, or registered investment adviser makes
              the investment decisions or if the plan has total assets in excess of $5 million.
             A charitable organization, corporation, or partnership with assets exceeding $5
              million.
             A director, executive officer, or general partner of the company selling the securities.
             A business in which all the equity owners are accredited investors.
             A natural person with a net worth of at least $1 million.
             A natural person with income exceeding $200,000 in each of the two most recent
              years or joint income with a spouse exceeding $300,000 for those years and a
              reasonable expectation of the same income level in the current year.
             A trust with assets of at least $5 million, not formed to acquire the securities offered,
              and whose purchases are directed by a sophisticated person, that is, a person with
              sufficient knowledge and experience in financial and business matters to make him or
              her capable of evaluating the merits and risks of the prospective investment.
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-12

    o It is up to the offering company to decide what information it gives to accredited
      investors, so long as it does not violate the SEC’s antifraud prohibitions.

             The company must give nonaccredited investors disclosure documents that generally
              are the same as those used in registered offerings. If the company provides
              information to accredited investors, it must make this information available to the
              nonaccredited investors as well.
             Here are some specifics about the financial statement requirements applicable to this
              type of offering:

              1. Financial statements need to be certified by an independent public accountant.
              2. If a company other than a limited partnership cannot obtain audited financial
                 statements without unreasonable effort or expense, only the company's balance
                 sheet, to be dated within 120 days of the start of the offering, must be audited.
              3. Limited partnerships unable to obtain required financial statements without
                 unreasonable effort or expense may furnish audited financial statements prepared
                 under the federal income tax laws.

Rule 506

   Rule 506 is a safe harbor for the private offering exemption. If a company satisfies the
    following standards, it can be assured that it is within the Section 4(2) exemption:

    o The company may raise an unlimited amount of capital.
    o The company does not use general solicitation or advertising to market the securities.
    o The company sells its securities to an unlimited number of accredited investors (the same
      group we identified in the Rule 505 discussion) and up to thirty-five other purchasers.
      Unlike Rule 505, all nonaccredited investors, either alone or with a purchaser
      representative, must be sophisticated.
    o The company decides what information it gives to accredited investors, so long as it does
      not violate the antifraud prohibitions. But the company must give nonaccredited investors
      disclosure documents that generally are the same as those used in registered offerings. If
      the company provides information to accredited investors, it must make this information
      available to the nonaccredited investors as well.
    o The company is available to answer questions by prospective purchasers.
    o The company meets the same financial statement requirements that we outlined for Rule
      505.
    o Purchasers receive restricted securities. Consequently, purchasers may not freely trade
      the securities in the secondary market after the offering.

9-4 VALUATION

All efforts to raise money for a business start with a valuation of the business idea or the existing
business at the time money is to be obtained.
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-13




   A business idea is not worth the same at launch as it will be when it is operational and,
    perhaps, profitable.
   Valuation is the term used to refer to the process of determining the monetary value of a
    venture.
   When financing is involved, valuation includes a pre-money and a post-money valuation
    figure.

    o The pre-money valuation is the value of the business as it is, without any new money
      added.
    o The post-money valuation is equal to the pre-money value plus the amount of capital
      added through the new investment.

   For a going business with an operating record, the valuation usually begins with the profit
    record and the cash flow record for the past years.
   There are factors other than return on investment to be taken into account when valuing a
    business such as: Stability of the key management, the trend in the industry of the company,
    a possibility of including additional products or services for increased revenues, is the
    customer base expandable, do investors add new value to the company through their contacts
    or talents.

    o All these factors and more can add or subtract value for a particular investor.
    o When an investor is considering the value of a venture that is offering new stock shares,
      the number of shares offered is of little relevance.
    o The key to the value of the investment is the percentage of the company’s equity that is
      being transferred.
    o The price per share is determined by valuing the company and then dividing that value by
      the number of shares outstanding after the new share transaction is completed.

   In the public markets, the calculation of the relationship of the total shares outstanding to the
    total value of the company is calculated constantly to determine the price per share.

    o The total number of shares issued multiplied by the market price of a share is known as
      the market cap, or market capitalization, of that company.
    o The price per share in the public markets includes an estimate of the future earnings
      potential of the company that issues the stock.
    o This future earnings estimate is called the multiple - the number of times the present
      earnings of the company is multiplied in order to arrive at the price/earnings ratio of the
      stock.

             The total shares outstanding in a company multiplied by the earnings of that company
              results in the market cap of that company.
Chapter 9: Capital, Valuation, and Exit Strategies                                         9-14



    o The multiple of a stock is the most important driver of the stock’s value. In an initial
      public offering (IPO).

             The multiple is the result of an intense negotiation between the issuer of the stock and
              the investment banker who will bring the issue to market.

    o After a stock is in the marketplace, the multiple is set by the collective wisdom of the
      marketplace.

9-5 EXIT STRATEGIES

The purpose of a venture’s exit strategy is:

   To outline a method by which the early-stage investors can realize a tangible return on the
    capital they invested.
   To suggest a proposed window in time that investors can tentatively target as their
    investment horizon, placing a limit on their involvement in the early-stage funding deal.

The problem in projecting an exit strategy is that it’s based on several major assumptions.

   The speed of market penetration,
   The ability to sell at expected price levels,
   The costs of doing business,
   The margins on sales,
   The management team’s ability to arrange consistent deals, and
   The impact of competition and other economic factors.

There are four basic categories of exit strategies. In order of occurrence, these strategies are:

   Acquisition: The venture initiates contact with a large supplier, distributor, or major
    competitor to be acquired.

    o The pitch to the potential acquirer is that the venture would add valuable cash flow to the
      acquiring company.
    o At the close of the deal, the purchase price is high enough to buy out the original
      investors at a premium on their initial investment.
    o The deal is built on the premise that the buyer needs the acquired firm to make its next
      leap of growth.
    o As such, the terms of the transaction will likely be more favorable to the acquiring
      company.
    o But a fair sales price based on post-deal increased sales and profits to the buyer should
      allow the original investors to realize a good return on their investment.
Chapter 9: Capital, Valuation, and Exit Strategies                                      9-15




   Earn-out: Is used for ventures that have begun to generate consistently strong positive cash
    flow.

    o The management team initiates a monthly or quarterly buyback of investors’ common
      shares at a premium over the initial investment cost.
    o An earn-out can be accomplished over three or four years and can provide the original
      investors with a strong return as company sales expand and costs decline because of
      increased operating efficiencies.
    o The purchase price is often scaled upward incrementally over time, as investors provide
      the luxury of time for the management team to complete the deal.

   Debt-equity swap: If the venture’s original funding was through a loan, the founders can
    incrementally trade common shares for portions of the principal on the debt.

    o This strategy slowly reduces the interest due over time and rearranges the balance sheet
      as liabilities are eliminated and replaced with equity positions.
    o If the firm is doing very well and has prospects for being acquired at a premium, debt
      holders have an incentive to switch to equity positions.

   Merger: Involves negotiations between the venture and another firm, but this time the deal is
    based on mutual needs and benefits.

    o The transaction will likely involve cash changing hands to arrive at the new company
      structure, and original investors can typically make their shares available for sale to close
      the deal.
Chapter 9: Capital, Valuation, and Exit Strategies                                      9-16


KEY TERMS

Accredited investors: Investors who meet a list of SEC criteria, making them eligible to invest
in private placements of stock.

Authorized stock: The number of shares that the company has available to sell at any point in
time.

Blank check companies: A development-stage company that has no specific business plan or
purpose.

Collateral: Something of greater value than the loan to provide security of repayment to the
lender.

Collective wisdom of the marketplace: The amount of money, or price per share, that the
buyers in the marketplace are willing to pay for a stock.

Debt capital: Funds that are obtained for a venture through borrowing and that must be paid
back.

Dividends: A distributed portion of the firm's earnings.

Elevator speech: A brief statement of the company and its goals that can be delivered in about
20 seconds or less, the time it takes to ride several floors in an elevator.

Equity capital: Funds that are obtained for a venture through investing and that do not have to
be paid back.

Exit strategy: The method by which investors can realize a tangible return on the capital they
invested.

Factoring: The practice of selling accounts receivable at a discount to a factoring firm.

Floor planning: The practice of assigning title to inventory to a lender for the purpose of
securing funds to stock inventory for sale.

Initial public offering: The initial offering of a company’s shares on a public stock exchange,
such as the New York Stock Exchange or NASDAQ.

Intrastate offering exemption: Section 3(a)(11) of the Securities Act; it facilitates the financing
of local business operations.

Investment Company: A company whose principle business is to invest in other companies
Chapter 9: Capital, Valuation, and Exit Strategies                                       9-17



Investment horizon: A proposed window in time targeted by investors so as to place a limit on
their involvement in the early-stage funding deal.

Issued stock: Shares in a company that have already been sold to investors.

Leverage: The use of debt to increase the return of equity.

Line of credit: A preapproved loan amount that an entrepreneur can borrow in part or in total
without additional application paperwork and as long as loan amounts are paid back.

Market capitalization: The total number of shares issued by a company multiplied by the
market price of a share.

Micro-loan: A loan that is under $5,000.

Multiple: An estimate of the future earnings potential of a company that issues stock.

Pledging: The use of accounts receivable as collateral for a loan.

Post-money valuation: The value of a business after investment capital has been obtained; the
post-money value is equal to the pre-money value plus the amount of capital added through the
new investment.

Pre-money valuation: The value of a business as it is, without any new money added.

Price/earnings ratio: The present earnings of a company times its multiple divided by present
earnings.

Private placement memorandum (PPM): A document that is used as a prospectus in a private
offering of stock. The PPM fully discloses information about the company that an investor needs
to know. Also, a statement that must be provided to investors purchasing a Regulation A
offering.

Promissory note: An instrument that states the obligation to repay a loan and the terms of
repayment.

Regulation A: A Securities Act exemption for public offerings not exceeding $5 million in any
twelve-month period.

Regulation D: A section of the Securities Act that outlines certain exemptions for public
offerings.
Chapter 9: Capital, Valuation, and Exit Strategies                                     9-18

Restricted securities: Securities that may not be sold without registration or an applicable
exemption.

Retained earnings: Earnings that the owners do not pay to themselves but rather leave in the
firm as an additional investment.

Revolving credit agreement: A guaranteed line of credit that remains available to an
entrepreneur without additional loan applications as long as each borrowed sum is paid back on a
prearranged schedule.

Secured loan: A loan that is backed by collateral, something of equal or near equal value to the
loan amount.

Securities Act of 1933: Federal legislation enacted to establish the Securities and Exchange
Commission; this act was a direct response to the stock market crash of 1929 and subsequent
Great Depression.

Securities and Exchange Commission (SEC): Federal agency that regulates the public sale of
stock in the United States.

Stock certificate: A document that indicates the name of the company, the number of shares
owned, and the special characteristics of those shares.

Term loan: A loan that must be paid back within a given time period.

Trade credit: Credit given to a firm by the trade, that is, by the suppliers the company deals
with.

Unissued stock: Authorized shares in a company that have not been sold.

Unsecured loan: Loans that are based solely on the good credit of the borrower.

Valuation: The process of establishing the value of a venture.

Venture capital: Funds provided to rapid-growth firms in exchange for a share of the ownership
and frequently a share of control.
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-19



PRACTICE QUIZ

    1. In the early stages, most ventures don’t generate sufficient capital from sales to sustain
       themselves. Answer: True
       Reference: 9-1

    2. One of the most common exit strategies is sell the venture to the highest bidder. Answer:
       False
       Rationale: One of the most common exit strategies is to sell the venture to a larger
       company.
       Reference: 9-1

    3. Short-term debt is used to finance current operations, with required payback within three
       years. Answer: False
       Rationale: Short-term debt is used to finance current operations, with required payback
       within one year.
       Reference: 9-2a

    4. To secure a loan with accounts receivables is called pledging. Answer: True
       Reference: 9-2a

    5. The bank preapproving a customer for an unsecured loan up to a certain amount means
       the customer enjoys a line of credit with the bank. Answer: True
       Reference: 9-2a

    6. Factoring is one of the most inexpensive forms of short-term credit. Answer: False
       Rationale: Factoring is a relatively expensive form of short-term credit.
       Reference: 9-2a

    7. “4/10 net 45” means that the buyer can take a 4 percent discount if the invoice is paid
       within ten days; if the discount is not taken, the full bill is due in forty-five days. Answer:
       True
       Reference: 9-2a

    8. Reduction of excess inventory helps a new venture generate both internal and external
       funds. Answer: False
       Rationale: Every dollar of excess inventory that is reduced represents one less dollar
       needed from outside sources.
       Reference: 9-2a

    9. One popular form of financing for new, small, or struggling businesses is venture capital.
       Answer: True
       Reference: 9-2c
Chapter 9: Capital, Valuation, and Exit Strategies                                         9-20



    10. Evidence of stock ownership is always a dividend payment. Answer: False
        Rationale: As evidence of ownership, a shareholder receives a stock certificate.
        Reference: 9-2c

    11. Which of the following is defined as “funds obtained through borrowing”?
        a. debt capital
        b. investment capital
        c. equity capital
        d. savings capital
        Answer: A
        Rationale: Debt capital is simply funds obtained through borrowing.
        Reference: 9-2

    12. Earnings that the owners leave in the firm as additional investments are called
        a. shares.
        b. profit.
        c. retained earnings.
        d. revenue.
        Answer: C
        Rationale: Retained earnings are earnings that the owners do not pay to themselves but
        rather leave in the firm as an additional investment.
        Reference: 9-2

    13. Loans that are based solely on the good credit of the borrower and that require no
        collateral are called
        a. credit loans.
        b. investment loans.
        c. unsecured loans.
        d. risky loans.
        Answer: C
        Rationale: Unsecured loans are loans based solely on the good credit of the borrower.
        Reference: 9-2a

    14. Credit given to a company by its suppliers is called
        a. trade credit.
        b. supply credit.
        c. inventory credit.
        d. supplier credit.
        Answer: A
        Rationale: Trade credit is credit given to a firm by the trade, that is, by the suppliers the
        company deals with.
        Reference: 9-2a
Chapter 9: Capital, Valuation, and Exit Strategies                                   9-21



    15. The primary sources of long-term debt for an entrepreneurial venture are term loans, SBA
        loans, and
        a. funding.
        b. credit.
        c. leverage.
        d. investments.
        Answer: C
        Rationale: The entrepreneurial venture has three primary sources of long-term debt: term
        loans, SBA loans, and leverage.
        Reference: 9-2b
Chapter 9: Capital, Valuation, and Exit Strategies                                      9-22


QUESTIONS TO BE DISCUSSED

1. What sources of funds should a sole proprietor of a hardware store consider when seeking to
   expand retail space through the purchase of an adjacent building? Explain.

    Suggested approach: The students should provide their opinion on the sources of funds that
    a sole proprietor of hardware store should consider when seeking to expand the retail space
    through the purchase of an adjacent building. The information provided below could serve as
    a background for the students to understand the concept discussed.

    The two major sources of funds for a business are debt capital and equity capital. Debt
    capital is simply funds obtained through borrowing. Equity capital, on the other hand, does
    not require repayment. These funds come from the current owners of the firm or from
    outsiders who provide capital in exchange for some ownership in the firm. Sources of equity
    capital include retained earnings, or earnings that the owners do not pay to themselves but
    rather leave in the firm as an additional investment; additional contributions of the owners,
    that is, additional money from the owners' personal sources; investments by outsiders in a
    privately owned firm, that is, adding new partners to bring in new capital; and stock issues to
    the general public, or stock sold to the public for capital. Exhibit 9-2 compares debt and
    equity capital.

    REF: 9-2

2. What sources of funds should an LLC consider when planning to expand operations
   dramatically in the Chinese market? Explain.

    Suggested approach: The students should provide their opinion on the sources of funds that
    a sole proprietor of hardware store should consider when seeking to expand the retail space
    through the purchase of an adjacent building. The information provided below could serve as
    a background for the students to understand the concept discussed.

    The two major sources of funds for a business are debt capital and equity capital. Debt
    capital is simply funds obtained through borrowing. Equity capital, on the other hand, does
    not require repayment. These funds come from the current owners of the firm or from
    outsiders who provide capital in exchange for some ownership in the firm. Sources of equity
    capital include retained earnings, or earnings that the owners do not pay to themselves but
    rather leave in the firm as an additional investment; additional contributions of the owners,
    that is, additional money from the owners' personal sources; investments by outsiders in a
    privately owned firm, that is, adding new partners to bring in new capital; and stock issues to
    the general public, or stock sold to the public for capital.

    REF: 9-2
Chapter 9: Capital, Valuation, and Exit Strategies                                     9-23



3. How would a hardware store sole proprietor establish a valuation for the venture? How
   would a hardware chain, such as Home Depot, establish valuation? Explain the similarities
   and differences.

    Suggested approach: The students should provide their opinion on how:

        A hardware sole proprietor would establish a valuation for the venture.
        A hardware chain, such as Home Depot, would establish valuation.

    The students are required to compare the two and provide the similarities and differences.
    The information provided below could serve as a background for the students to understand
    the concept discussed.

    In order to raise funds, one of the questions as entrepreneurs must be able to provide answers
    for is:

        What is the value of the venture?

    Venture valuation can be calculated using several techniques. Depending on the
    sophistication of the funding source, the entrepreneur may need to use one or another of the
    techniques. Venture capitalists, for example, use complex financial models to track and
    monitor their investments.

    REF: 9-1

4. Explain how an entrepreneur can legally raise equity capital in the amount of $1 million to
   fuel growth.

    Answer: Sources of equity capital include retained earnings, or earnings that the owners do
    not pay to themselves but rather leave in the firm as an additional investment; additional
    contributions of the owners, that is,

             Additional money from the owners' personal sources; investments by outsiders in a
              privately owned firm, by adding new partners to bring in new capital; and stock
              issues to the general public, or stock sold to the public for capital.

    REF: 9-2

5. What is the purpose of an exit strategy? Describe two exit strategies and explain how an
   entrepreneur might use these strategies in a fund-raising pitch.

    Answer: The first purpose of a venture’s exit strategy is to outline a method by which the
    early-stage investors can realize a tangible return on the capital they invested.
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-24



        The entrepreneur spells out a reasonable scenario, the exit strategy, by which a later
         round of funds will be raised. This later round should provide the original investors with
         an opportunity to sell their shares and realize a capital gain. The entrepreneur’s scenario
         should avoid the mistakes.

        Second, the intent of an exit strategy is to suggest a proposed window in time that
         investors can tentatively target as their investment horizon, placing a limit on their
         involvement in the early-stage funding deal. The founding team wants to assure investors
         that the venture will grow to a point whereby the initial investors can cash out their stakes
         at a high return, given the significant risks they assumed when they decided to fund the
         venture.

    REF: 9-5

6. What is the difference between long-term debt and equity capital? Why would an
   entrepreneur choose one over the other?

    Answer: Equity capital funds come from the current owners of the firm or from outsiders
    who provide capital in exchange for some ownership in the firm. Sources of equity capital
    include retained earnings, or earnings that the owners do not pay to themselves but rather
    leave in the firm as an additional investment; additional contributions of the owners, that is,
    additional money from the owners' personal sources; investments by outsiders in a privately
    owned firm, that is, adding new partners to bring in new capital; and stock issues to the
    general public, or stock sold to the public for capital

    On the other hand a long-term debt is one which a venture should plan for. Successful
    companies constantly refocus on their long-term goals and objectives. If the venture has an
    objective to maintain a certain level of growth, it must provide the funds to pay for that
    growth. If a company knows its objectives, it needs to look at possible sources of long-term
    capital to help it accomplish those objectives.

    REF: 9-2, 9-2b

7. What are the primary sources of short-term debt? What is trade credit.

    Answer: Short-term debt is used to finance current operations, with required payback within
    one year. The entrepreneur in the early stages of a venture spends a lot of time seeking and
    obtaining short-term financing, generally when funds needed for day-to-day operations are
    not sufficient. Short-term financing can come from several different sources: family and
    friends, commercial banks, trade credit, credit cards, and internal funds management.
Chapter 9: Capital, Valuation, and Exit Strategies                                         9-25



    Another widely used source of short-term financing for entrepreneurs is trade credit. Trade
    credit is credit given to a firm by the trade that is, by the suppliers that the company deals
    with.

    REF: 9-2a

8. How can an entrepreneur maintain control of the venture through the fund-raising process?
   Explain.

    Answer: In the fund-raising process, the entrepreneur must to be able to justify the proposed
    value of the venture and to be able to explain to potential investors how they will exit from
    their commitment. In addition, to raise capital in the United States, entrepreneurs must follow
    rigorous laws and guidelines handed down by the Securities and Exchange Commission
    (SEC). These laws were developed to protect investors from scams and over-inflated
    statements about a company’s prospects. Despite the hurdles to raising money, most
    entrepreneurs learn the method that can be followed to systematically approach and pitch to
    investors.

    REF: Chapter summary

9. What is meant by the term elevator speech? Give an elevator speech for the Numi Tea
   Company described in the Entrepreneur’s Story at the beginning of this chapter (hint: see
   www.numitea.com).

    Suggested approach: An elevator speech is a brief statement of the company and its goals
    that can be delivered in about 20 seconds or less, the time it takes to ride several floors in an
    elevator.

    Students should create an elevator speech for the Numi Tea Company. They can use
    www.numitea.com to get a background on the company before they proceed.

    REF: 9-1

10. What is an offering circular? What information should be included in an offering circular?

    Answer: Section 3(b) of the Securities Act authorizes the SEC to exempt from registration
    small securities offerings. By this authority, the SEC created Regulation A, an exemption for
    public offerings not exceeding $5 million in any twelve-month period. If a venture chooses to
    rely on this exemption, it must file for the SEC’s review an offering statement consisting of a
    notification, offering circular, and exhibits.

        Companies may choose among three formats to prepare the offering circular, one of
         which is a simplified question-and-answer document.
Chapter 9: Capital, Valuation, and Exit Strategies   9-26



    REF: 9-3c
Chapter 9: Capital, Valuation, and Exit Strategies                                     9-27




RUNNING CASE: COMMUTER COFFEE

“Source of Capital, Valuation, and Exit Strategies”

Introduction: All members were present when Carlos called the meeting to order. Carlos stated
that he and Shena had discussed their objection to the $140,000 for total capital and decided to
withdraw their objection in favor of the more conservative approach.

Questions for Discussion

1. If you were one of the founders of this company, would you be willing to sign a personal
   guarantee on the SBA loan? Why or why not?

    Suggested approach: The students should consider themselves as one of the founders of the
    Commuter Coffee company and provide their opinion on whether they would be willing to
    sign a personal guarantee on the SBA loan. Further the students are required to substantiate
    their answer by justifying the reason for their choice. The information provided below could
    serve as a background for the student to understand the concept of SBA.

        For a smaller business, the U.S. Small Business Administration (SBA) can often be a
         good source of loans.

         o The SBA, by guaranteeing major portions of loans, enables its lending partners to
           provide financing to small businesses when funding is otherwise unavailable on
           reasonable terms.
         o The agency does not have funding for direct loans, nor does it provide grants or low-
           interest loans for business start-up or expansion.
         o The eligibility requirements and credit criteria of the program are very broad in order
           to accommodate a wide range of financing needs to qualify for an SBA guaranty.
         o A small business must meet the SBA’s criteria, and the lender must certify that it
           could not provide funding on reasonable terms without an SBA guaranty.
         o Most cases, the maximum guaranty are $1 million. There are higher loan limits for
           international trade, defense-dependent small firms affected by defense reductions and
           for certified development company loans.

    REF: 9-2b

2. In your own words, describe the capitalization plan for Commuter Coffee’s second and third
   years of operation. What do you think of the capitalization plan decided on by the founding
   team?
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-28

    Suggested approach: The students should describe the capitalization plan for Commuter
    Coffee’s second and third years of operation. They should also provide their opinion on what
    they think of the capitalization plan decided on by the founding team.

3. Explain the valuation that is being used to raise funds for the second and third years of
   operation. Do you agree with this value? Explain. What is the exit strategy for this venture?

    Suggested approach: The students should provide their views of the valuation methodology
    used by Commuter Coffee group to raise funds for the second and third years of operation.
    Further the students should provide their opinion on whether they agree with the value. The
    information provided below could serve as a background for the student to understand the
    concept of venture valuation.

    Venture valuation can be calculated using several techniques. Depending on the
    sophistication of the funding source, the entrepreneur may need to use one or another of the
    techniques. Venture capitalists, for example, use complex financial models to track and
    monitor their investments.

    The students should also provide their opinion on the exit strategy for this venture. The
    information provided below could serve as a background for the student to understand the
    concept of exit strategy.

    The first purpose of a venture’s exit strategy is to outline a method by which the early-stage
    investors can realize a tangible return on the capital they invested.

        The entrepreneur spells out a reasonable scenario, the exit strategy, by which a later
         round of funds will be raised. This later round should provide the original investors with
         an opportunity to sell their shares and realize a capital gain. The entrepreneur’s scenario
         should avoid the mistakes.
        Second, the intent of an exit strategy is to suggest a proposed window in time that
         investors can tentatively target as their investment horizon, placing a limit on their
         involvement in the early-stage funding deal. The founding team wants to assure investors
         that the venture will grow to a point whereby the initial investors can cash out their stakes
         at a high return, given the significant risks they assumed when they decided to fund the
         venture.

    REF: 9-1, 9-5
Chapter 9: Capital, Valuation, and Exit Strategies                                       9-29



EXPERIENTIAL EXERCISE 1

“Visit an Online Business Brokerage”

Introduction: Since it was launched late in 1996, BizBuySell has become the Internet's largest
business-for-sale site. Of the more than 10,000 listings in its databases, some 15 percent are
listed by personal owners, and the remainder comprises about 700 business brokers.
Manufacturing businesses account for 15 percent of the businesses listed; wholesale and retail
for 40 percent; and services make up roughly 30 percent. Of the thousands of people who visit
the site, most are looking for a business to buy. Not only may buyers search the database at no
charge, they may also register to be notified about new business listings that match their
interests.

Suggested approach: Students should visit the BizBuySell website, www.bizbuysell.com and
explore the variety of businesses listed there for sale. Each student selects a category to explore
and picks at least five small businesses that are listed for sale on the site. For each business
selected, students should make a note of the following information:

   Asking price
   Gross sales
   Cash flow
   Inventory
   Financing options

Based on this research and understanding the students should compare the five businesses
selected and solve the following questions:

1. Which one seems to offer the best deal?
2. Which one seems to have the highest valuation? Why?
3. Among the various industries, which ones seem to have the highest multiples of gross sales?
   Why?
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-30


EXPERIENTIAL EXERCISE 2

“Learn to Ask for Money”

Introduction: Entrepreneurs must be able to ask for money. More, they must be able to ask for
money in a manner that secures a check at the earliest possible date. Many entrepreneurs go into
business expecting the cash from operations to be sufficient to pay bills and fuel growth. That
rarely occurs. Most entrepreneurs are unprepared when it comes to asking for money. Worse,
most are unprepared to actually ask for and receive a check.

Suggested approach: A student should play the role of the entrepreneur; he or she should be
given a few minutes to prepare a pitch and to develop a technique to make the “ask.”

The other class members should observe the interaction and, when completed, provide solutions
to the following questions:

1.   What did the entrepreneur do right in making the ask? What did he or she do wrong?
2.   Did the entrepreneur use the valuation appropriately?
3.   Did the entrepreneur mention the exit strategy?
4.   What are the hot buttons that need to be a part of a pitch for money to a venture capitalist?
5.   Did the entrepreneur create a sense of urgency? Did he or she get the check?
Chapter 9: Capital, Valuation, and Exit Strategies                                        9-31



OTHER RESOURCES

Websites of interest:

National Venture Capital Association
http://www.nvca.org/

U.S. Securities and Exchange Commission
                                   http://www.sec.gov/

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