ENTREPRENEURIAL FINANCE OUTLINE FALL 1998 SMITH/SCOTT General Point of Course -insights into patterns of success 1. point - can turn any business into gazelle by duplicating patterns a. entrep personality & qualifications b. recognizing opportunity c. running verifiable economic tests d. adopting business plan e. methods of raising money 2. source - different case studies Part I - Financial Growth Cycle I. Getting Started -considerations from outset 1. personal - entrep a. operation in high risk, imperfect info, quick judgmt atmosphere b. willing to painstakingly solicit money c. convincing conservative investors to invest in you 1. initial round 2. secondary round if necessary 3. investor recovery - exit via IPO, M&A, LBO 2. financing a. correlation w/volatility of mrkt 1. most money in mrkt goes to larger expansion co. already passed the start-up stage 2. first place money dries when mrkt in downturn b. types of financing for different stages of co. developmt 1. start-up - initial capital from gorilla financing (self including credit cards), MCI (friends & family) 2. expansion - angels ($250k-$2m) 3. gazelle (potential of growth greater than 50%) - VC ($3.9 average, institutional), private equity (directly from institutional investors, lg amts) lifestyle co. - growing less than 25%/yr not going to go public a. owners - like b/c steady income b. VC - don’t like b/c no lg payoff at end & illiquid debt if can get it II. Small Co. Are Different -opportunity recognition - Timmons 1. types of start-up firms a. lifestyle firms b. high potential - annl sales of $500k - $1m, grow at least 10% annl c. foundation firms 2. characteristics of successful firms - circular in my mind a. more employees the better b. greater sales the better c. expansion/cash flow/longterm value potential d. quicker growth in beginning increase chances of survival e. startup financing from VC 1. usually lose on 15-20% on investmt portfolio 2. remainder of portfolio - 25% annl return after taxes provided primarily by 10-15% of high performing portfolio 3. determinants of success a. right people
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1. ability to recognize patterns in previous successes 2. proven track record/experience a. enables recognition of opportunity before window closes 3. knowledge of mrkt & contacts 4. strategy - business plan b. right opportunity 1. opportunity is subset of ideas a. condition for creation of opportunities 1. when laws change 2. when there is fragmentation in mrkt 2. durable a. significant profit/growth protential b. expandable into other areas 3. timely a. limited window of opportunity b. potential mrkt share where mrkt has not fully matured 1. average about 15yrs but varies w/mrkts 2. 30-50% annl growth rate attractive 3. 20% mrkt share attractive 4. consider # of sellers 5. distribution of sellers 6. differentiation of products 7. sensitivity of demand to changes in price 4. competitive advantage a. value to end-user fills need in enough quantity to real consumers 1. perhaps consider different product or application of core opportunity 2. identify customers 3. customers are reachable 4. customers no other competing loyalties b. consider if there are barriers to future entry for competitors c. costs of production 1. lower fixed costs 2. more room for error d. control over distribution 5. harvesting potential a. identifiable, repeatable, verifiable 1. require existing mrkt b. profits after taxes - 10-20% c. break even earlier - 2yrs preferably d. return on investmt - 25% + f. strategic value of exit - IPO or sale warnings 1. don’t follow exceptions to the rule like IBM, Xerox 2. best technology or idea doesn’t necessarily mean success a. not just about focusing on continually improving product but about what will sell 3. bad mrkts a. highly concentrated b. perfectly competitive c. mature/declining 4. make sure no fatal flaws c. adequate resources 1. nonprohibitive capital requiremts III. Working W/Angel Investors -sources of equity 1. public
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a. NYSE - top tier 1. auction mrkt a. facilitator - specialist for each co. who records orders & sales of its shares 2. requiremts to be on list a. $40m public float (shares available for public purchase) or net tangible assets of $40m b. pretax earnings or mrkt cap (mrkt value of all outstanding shares) of $500m & revenues of $200m b. NASDAQ NMS (National Assoc of Securities Dealers Automated Quoting System Natl Mrkt) - 100 1. dealer mrkt - mrkt makers 2. electronic mrkt 3. listing requiremts - pure mrkt cap test a. $75m mrkt cap & public float even if no earnings or revenues, or b. $18m public float + $18m net tangible assets c. NASDAQ SCM (Sm Cap Mrkt) 1. listing requiremts a. $4m net tangible assets, or b. $50m mrkt cap, or c. $750k net income d. bulletin board - less liquid ways to become public co. a. register under 1933 Act b. over $10m in assets & 75 or more shareholders in a class 2. private a. mezannine financing - bridge financing for pre-public time usually 1yr b. VC - institutional, professionally managed, organized as LLP, $100m size 1. $3.5m investmt - 500 funds w/$10b invested/yr in 10deals a. usually in high tech, biotech, healthcare industries (80%) 2. W/E coast 3. 3yr recovery period/exit 4. participation - more than 1 seat on board membership, networking 5. 30-50% preferred convertible 6. not ordinarily invest in emerging co. unless tremendous growth potential ($40m in 4/5yrs) 7. pricing VC investmt - Morris choice btwn highest valuation or best investors higher return - requires less ownership a. ROI or IRR depnding on risk & expected return 1. risk - product, mrkt, mgt 2. potential of co. - size, horizon, comps on sales, operating costs, gross profit, overhead admin expenses, net profit, PE, ROE 3. financial projections 4. future dilution 5. time 6. performance to date 7. capital gains vs. current income b. current mrkt conditions 1. supply of VC 2. demand for investmts by investors c. different risk at different levels 1. initial investmt requires higher rates of return than subsequent financings b/c lower preceived risk d. traditional pricing 1. profit requiremt - 5 times invested amt to be recovered in 4yrs - 50% annl compounded return 2. no explicit adjustmt for risk
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c.
d. e. a.
3. PE 15 in yr4 (price per share/earnings per share) - smaller the better? a. higher earnings - smller PE good b. lower earnings - lger PE e. fundamental pricing 1. VC seeking total porfolio return 20%+ compounded annl 2. % of VC equity in co. = compounded earnings on new investmt/total pretax projected earnings for co. f. First Chicago Pricing 1. successful venture if can be sold to public 2. sideways - not viable public co. but can service debt 3. failure angel - individuals (former entrep) 1. $50k - $3m investmt 2. geo localized 3. 5-7yr recovery period 4. participation - board membership 5. common stock - 7-10% ABC Corp Memo of Terms - 1/23/97 1. investor a. right of first refusal b. info rights c. registration rights 1. demand rights 2. co. registration 3. expenses 4. transfer of rights 2. security a. type b. number of shares c. price d. investmt amt e. rights 1. dividends 2. liquidation preference 3. conversion 4. antidilution 5. redemption 6. voting rights 7. protection 8. sale of assets or merger 3. co. a. proprietary agreemts b. board rep c. stock option pool 3. deal a. closing b. purchase agreemt friends & family self valuations HBS methods 1. comparables a. based on risk, growth rate, cap structure, size & time of cash flows 1. issue - such info not that public
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b. PE, equity/revenue, equity/bk equity, EBITA (earnings before interest & tax) c. other 1. industry specific factors 2. illiquidity discount 2. NPV a. discount rate - WACC (cost of equity from CAPM) 1. takes into account of tax benefits 2. can be adjusted to take inflation into account b. terminal value via growing perpetuity method (PV = c/r-g) c. strengths 1. provides range of values d. wknesses 1. need to calculate accurate to calculate discount rate a. similar financial performance, growth prospects, operations 2. target capital structure comparables 3. terminal value sensitivity to discount & terminal growth rates 4. may not be appropriate measure of risk (firm size or bk/mrkt ratio) 5. changing capital structures & tax rates 3. APV (adjusted PV) a. uses discount rate that ignores capital structure - CAPM & not WACC b. value tax deductions (net operating losses) separately - discount rate is interest rate on debt pre-tax a. strengths 1. preferred when co. capital structure is changing b/c ignores capital structure 2. preferred when net operating losses can be used to offset taxable income 4. VC method a. terminal value calculation w/high discount rate (40-75%) 1. terminal value - PE ratio times multiple of projected net income of exit yr 2. discount rate - target rate of return instead of WACC b. use this terminal value to determine desired ownership interest in co. assuming no future dilution 1. proposed investmt/discounted terminal value 2. future dilution taken care of w/retention ratio - required current ownership = required final % ownership/retention ratio a. retention ratio = current % ownership divided by (1+ % of co. shares sold) divided by (1 + additional % co. shares sold) divided by current %ownership c. situation 1. negative cash flow for while 2. uncertain but substantial future return d. strengths 1. compensate for illiquidity 2. compensate for value added efforts of VC 3. compensate for entrep inflated projections e. wknesses 1. should value each aspect separately 5. options analysis a. accounts for follow on investmts b. Black Sholes option pricing model - call/put options c. wknesses 1. not well known 2. formulas not always appropriate 3. complicated 3. debt - less hope than equity a. commercial loans
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asset based cash flow based third party guarantee banks not likely source b/c they consider a. borrower’s record b. repaymt b. SBA (Sm Business) backed loans 1. requiremts - operating history, owner’s personal guarantee on at least 25% of amt c. SBIC (Sm Business Investmt Co.) 1. investmt co. that uses SBA $ to leverage own equity to invest in entrep co. 2. usually preferred stock investmts of $300k - $5m d. mortgage one’s assets e. credit cards 4. other a. strategic alliances 1. larger co. in same industry for synergies 2. usually involve equity for shares but not for complete control b. customer/supplier 1. ie, printer financing magazine by delaying paymt until sales made c. factors 1. asset based financing a. selling cash flows b. selling equipmt & leasing back d. credit terms 1. speed up collections & slow down paymts e. state programs -stages of equity - Posner 1. embryonic - researching - self & friends financing 2. seed - looking for mgt w/strategy - angel 3. start-up - some mgt, operational - angel & VC 4. expansion - showing growth - VC & capital mrkts IV. Angel Networks - ACE-Net - govt sponsored network to match entrep & angels 1. conditions a. only common stock - debt can’t be converted, 1 vote b. nonpublic entrep c. investor - accredited (net worth $1m, $200k/annl income), to provide guidance 2. mrkt a. current - 250k angels investing $20b in 30k co. b. ideal - 1.5-2.5m angels investing $60b in 350k co. 3. benefits a. alleviate high transaction costs due to lack of organization b. alleviates costs via model term sheet for investmt PART II - GROWING THE COMPANY THROUGH THE FINANCIAL LIFE CYCLE I. Legal Requiremts & Regulation -business plans -K -role of attorneys 1. best legal structure to attain business goal 2. assessmt & disclosure of risks of varying actions 3. make sure K are enforceable II. Putting It All Together -Auto America- used car sales & financing 1. stages of developmt
1. 2. 3. 4.
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a. seed stage 1. business plan co. a. goal b. how achieve c. co. organization mrkt info a. mrkt base analysis & growth potential b. revenue info c. risk assessmt d. comparables gen a. list of assumptions b. sample transaction c. single store financials & projections d. multiple store financials & projections 2. mgt a. background/track record b. personal capital c. familiarity w/industry b. start-up 1. operational a. refine mrktg c. expansion 1. acquisitions 2. improvemts 2. financing a. personal b. private placemt c. asset back securities d. IPO advice 1. have to be flexible 2. have to be practical 3. know that looking for financing is expensive - fees, interest, etc. 3. exit strategy a. IPO b. merger c. sale of co. d. securitize cash flow picking project - focus on profit margin -VC Method of Valuation of High-Risk, Long-Term Investmts - HBS 1. basic method a. assuming no dilution b. equations 1. required FV of investmt = (1+ IRR)^yrs (investmt) 2. terminal value = P/E (terminal net income) 3. final ownership required = required FV of investmt / terminal value 4. final ownership required = investmt/PV 5. % ownership required = new shares / (old + new shares) 6. share price = investmt/new shares c. implied valuation 1. post$ valuation = investmt/%ownership acquired 2. pre $ valuation = post $ valuation - investmt
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2. a.
b.
c.
d.
3. a.
b. c. 4. a.
3. implied values a. expertise & connections b. option to abandon or invest more 4. securities a. entrep - common stock b. investors - preferred w/liquidity preference, dividend option elemts of VC method stages of investmt 1. seed - 80% discount rate 2. start-up - 50-70% 3. first stage - 40-60% 4. second stage - 30-50% 5. bridge financing - 20-35% 6. restart financing lower risk of failure, more assets discount rate 1. affects required ownership valuation share price : like 0 coupon bond 2. base rate of return - compensation for inflation 3. systemic risk premium - can’t diversify away a. mrkt, industry fluctuations b. higher for young companies - higher 4. liquidity premium a. lack of sufficient info b. legal restrictions c. shallow mrkt 5. value addition a. value of capital asset b. services 6. cash flow adjustmt a. balance - high enough to cover other losses in portfolio & low enough to not drive entrep 1. 25% of portfolio meet or exceed projections 2. 25% fail to return all invested capital 3. 50% modest returns 7. change over time terminal value calculation 1. mrkt share 2. PE & projected net income 3. revenue multiplier size of investmt 1. anticipate future financing needs 2. VC needs - max & min to justify costs valuation assuming future dilution method 1. estimate terminal value 2. allocate to current & future investors & founders 3. convert to current ownership, # of shares & price per share a. retention % = final % ownership / current % ownership b. new shares = [%ownership/(1-% ownership)] old shares value of staged capital commitmt 1. value of option to abandon mgt shares sum forecast results
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b. determine value c. determine capital needs to attain goals d. determine allocation of shares 1. mgt shares 2. investors - risk premium, illiquidity premium, value added premium, past experience premium e. convert back to present f. what can go wrong, right & reasonableness of projections -VC - Wetzel - finding financing tips 1. min requiremts for VC a. $10m revenue w/in 5yrs, 20% annl compounded growth, 15% pretax profit margin best - $50m revenue in 5yrs, 30-50% annl compounded growth, 20% pretax margin 2. advice a. start early - takes about 6mos. b. business plans imperative 1. investor oriented 2. what is vision 3. how achieve it 4. when achieve it c. seek professional advice 1. legal 2. accounting 3. business d. find right investors 1. consider as if buying capital about complemting each other to achieve shared goal a. price demanded b. investor exit expectation c. future finance availability d. investor mgt assistance value e. investors experience w/illiquid, high risk investmt 2. keep frequent contact w/investors a. info - financials, status report b. advice - board, consulting e. do due diligence 1. by investor - 6-8wks a. background checks on mgt b. industry c. competition d. risks 2. by entrep a. investor qualifications - references, resume, bank accounts f. emphasize nonfinancial payoffs of investmts 1. social utility - job creation, community revival, minority assistance g. pricing deal 1. require big winners to offset losers in portfolio a. return overall is little higher than mrkt on equity 2. ownership division compensating VC for risk 3. longer track record - cheaper 4. more expected value in end - cheaper 5. shorter holding period - cheaper h. structuring deal 1. terms a. amt of investmt b. form of investmt c. share of equity 1. angels - usually take common stock
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2. VC - take convertible preferred 3. SBIC - take subordinated debt w/convertible options d. terms & conditions i. determine harvesting strategy 1. time - IPO, M&A, sale, LBO 2. method 3. stages of developmt a. seed - research stage b. startup - begin operations c. first stage - full scale operations d. second stage - expansion e. mezzanine - starting to break even f. bridge - right before going IPO or exit III. Investing in Start Ups - Investor Point of View -Emerald Planet - wrap restaurant 1. structure of investor deal a. LLP - GP mgt/entrep & LP investors b. investors get 100% of revenue until recoup investmt & then split btwn GP & LP 2. business plan a. goal b. mrkt c. product d. location e. competition f. risk factors g. mrktg strategy h. mgt i. use of proceeds j. financial projections 3. finding financing 4. finding advisors IV. VC Valuation Case -issues 1. opportunity identification a. how assess opportunity once identified 2. financing a. how much $ entrep should raise b. from whom should entrep raise $ 1. strategic partner benefits a. provides access to infrastructure - mrktg, distribution, supplies b. eliminates potential competitor c. longer time horizon d. operational support e. deep pockets f. potential future opportunities for entrep disadvantages a. give up more control 2. VC as partner disadvantages in case like this a. can’t contribute much beyond $ b. goal to cash out c. no potential opportunities for entrep 3. deal
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a. is proposed deal reasonable 1. equitable to parties 2. balance btwn need for money & not being unfairly taken advantage of b. from whose perspective is deal reasonable 1. consider what investor benefits besides payoff when pricing 2. consider also what entrep brings to table c. timing matters 1. valuations 2. benchmarks d. which terms are potential deal breakeres e. what changes should be made to agreemt 1. what should entrep do - take or leave it or renegotiate -Parenting - HBS 1. initial meeting w/investor a. release form - find out risks & consequences of signing 2. investor agreemt terms a. pricing b. benchmarks for capital contributions 1. default leads to lien on project c. divorce term d. buy out 1. investor option to buy in 3yrs at capped price 2. entrep no option to buy investor out 3. finding right investor a. contribution 1. money 2. knowledge b. interest V. Valuation of VC Investmts -Greenscape - Minnick 1. seed stage - identifying an opportunity a. mrkt w/profit margin 1. benefits from economies of scale b. business plan 1. mrkt 2. concept a. consider factors that could affect business opportunity 3. plan for growth 4. margins 5. projected income & cash flow 6. mgt 7. barriers to entry 8. strengths 9. weakness/risks 10. exhibits a. articles & statistical info of mrkt b. model ctr c. mgt resumes d. pro forma financials - balance sheet & operating statemt 2. start up a. find right partner & other mgt b. finding financing 1. think about cash flow based lenders 2. budget self c. consultants
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VI. Private Equity Investing -Economics of Private Equity Mrkt - Fed Reserve 1. intro - overview of private equity mrkt 2. dev of private equity mrkt - history 3. issuers in private equity mrkt - those who don’t have access to debt & public equity mrkt a. early stage ventures b. later stage venture c. middle mrkt private firms - to finance change in ownership or capital structure d. firms in financial stress - private, public e. public buyouts f. other public firms - sm, complex transaction funding easier to sell to select few 4. intermediaries in private equity mrkt - partnerships, direct investmts a. mgt of private equity investmts in LLP structure - institutional investor LP, professional mgrs GP b. services provided - investmt selection, due diligence, syndication, structuring investmts c. monitor of issuer 5. investors in private equity mrkt - corp & public pension funds (lgest), endowmt/foundations, bank holding co., wealthy families & individuals, insurance co., investmt banks, nonfinancial corp 6. agents & advisers - to portfolio firms, LLP, institutional investors a. info producers - help in search of equity capital sources, institutional investors b. advisory services - structure, time, price, negotiations 7. returns on private equity investmts & determinants - IRR -bank users 1. those w/out access to capital mrkts - bonds & equity 2. complex operations too complicated for capital mrkt investors -Aberlyn Capital Mrkt, July 1993 - HBS 1. FLIP (financial lease on intellectual property) a. purchase of equipmt or patent & lease back w/option to sell back & w/warrant coverage 1. valuation like a put option w/stream of income in interim like bond a. similar to venture valuation 1. can be worth a lot - success 2. can be worth nothing - failure 2. warrant coverage - option to purchase shares in biotech co. b. benefits 1. provides financing for biotech co. w/out giving up too much equity 2. no debt on biotech co. financials c. problems 1. valuing assets to buy & buying right one - separate classes of risk 2. reselling 3. monitoring 2. pay attention to purpose of transaction by looking at terms & financials VII. Investing in Small Co. -CCC Info Services Group, Inc. - Dave Phillips, IPO prospectus 8/96 1. co. info a. service/product - auto claim info & processing software b. clients 1. auto insurance co. 2. auto repair co. c. internal d. mrktg e. mgt 2. risk factors 3. dilution 4. use of proceeds 5. financials a. operating results
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b. capital structure - stocks, options, etc. VIII. Dealing w/Problems in Entrep Fin: Job of CFO -Sepracor - Victor Woolley - 15yrs? 1. picking opportunity a. picking product - separation process tech, outlicensing, production 2. financing - 12 transactions to raise $100m,using $40m/yr ($240m accumulated loss so far) a. seed capital 1. friends & family 2. less than $1m 3. expensive 4. purpose - developing business plan b. VC 1. private VC & corp 2. $2-8m 3. modest valuations 4. purpose - bldg value (tech, mrktg, products) c. corp partnership 1. joint venture, tech sharing 2. good value 3. problems a. potential to get pushed around by bigger partner - control or mrktg decisions d. debt 1. equipmt leasing, commercial bank loan (secured w/IP), convertible debt 2. low value 3. expensive - balance sheet mgt (cost, time, attention) but should get whenever can even if don’t need it e. mezzanine 1. public/private investmt funds, insurance - these investors like short time horizon 2. significant $ 3. fair value 4. usually before IPO f. IPO 1. Wall St., SEC, institutional investors 2. lots of $ 3. fair value 4. purpose - growth g. spin offs 1. selling peripheral tech or divisions 2. lots of $ 3. fair value 4. purpose - strategic, raising capital co here 1. seed capital 2. VC 3. joint venture 4. preferred to other private 5. private placemts 6. bank loan 7. follow on’s use of funds 1. fund R&D 2. fund acquisitions so that co. looks like it’s actually producing something before IPO -private equity - source & uses - Bradfor, Smith 1. intro
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a. b. c. d.
fastest growing corp finance mrkt organizational structure - LLP stronger competition larger investmts, larger projects, faster turnover industries reliant on private equity - greater than 50% in order of % reliance 1. computer related 2. med & health 3. other business services 4. telemcom 2. private equity sources a. weathly individuals & families b. investmt & commercial banks c. their clients - pension funds, etc. general 1. those searching for higher returns 2. changes in law permitting such investmts 3. expected returns a. compensation high for high risk 1. fragile co. 2. illiquid investmt b. compensation for value added by investor 1. sitting on board 2. mgt system 3. connections to other resources - banking, legal, financial theory that IPO pricing 1. underpriced - tendency for prices to rise once trade on secondary mrkt 2. overpriced - over long run, price tends to decrease 4. entrep concerns a. investor push to IPO - average 2-3yrs 1. leads to more dilution of ownership 2. more responsibilities - disclosures to SEC, legal, accounting but good for mrkt liquidity b. giving up lots of equity to investors - average 44% 5. advice to entrep a. can estimate break even point for private equity investor based on liquidity adjusted portfolio of sm cap stocks b. encourage competition from investors to get lowest return demanded in return for investmt c. review alternative finance methods & value enhancemts 1. get adviser 2. # - decrease expenses, push for better terms w/customers & suppliers 3. borrow $ - increase debt capacity 4. use equity efficiently, effectively - give to people close to co. who know risks, etc. so don’t need to give up as much (or provide as high of a return) 5. become legit co. - good K, good mgt system, strong relationship to investmt & financial communities IX. Bringing Co. to Life -Ken Langone - Home Depot 1. key to entrep success a. identify opportunity early on b. be aggressive but don’t lie or promise what can’t deliver c. be optimist -Ken Langone 1. entrep projects a. Home Depot b. Electronic Data Systems Corp.
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c. d. 2. a. b.
Unifi, Inc. Patlex Corp. works at Invemed Associates - investmt bank raise $ for corp clients find investmts for $ managers
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